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Module - Basic Financial Accounting and Reporting For Bsba
Module - Basic Financial Accounting and Reporting For Bsba
Learning Objectives:
Chapter 1
DEFINITIONS OF ACCOUNTING
Accounting is the art of recording, classifying and summarizing in a significant manner and in
terms of money, transactions and events which are, in part at least, of a financial character,
and interpreting the results thereof.
TYPES OF BUSINESS
SERVICES- An entities or individual that provides services to the public. Examples are software
developer, accounting and legal, colleges and universities, barbershop, salon and other
services.
TRADING – An entities or individual that buys and sells the products (buying and selling).
Examples are supermarket, department store and others.
MANUFACTURING – An entities that convert materials into finished products. Examples are
furniture’s production, noodles production, shoes manufacturing, garment factories and food
processing.
Partnership. A partnership is a business owned and operated by two or more persons who
bind themselves to contribute money, property, or industry to a common fund, with the
intention of dividing the profits among themselves. Each partner is personally liable for any
debt incurred by the partnership.
FUNDAMENTAL CONCEPTS
Several fundamental concepts underlie the accounting process. In recording business
transactions, accountants should consider the following:
Entity Concept. The most basic concept in accounting is the entity concept. An accounting
entity is an organization or a section of an organization that stands apart from other
organizations and individuals as a separate economic unit. Simply put, the transactions of
different entities should not be accounted for together. Each entity should be evaluated
separately.
Periodicity Concept. An entity’s life can be meaningfully subdivided into equal time periods
for reporting purposes. It will be aimless to wait for the actual last day of operations to
perfectly measure the entity’s profit. This concept allows the users to obtain timely information
to serve as a basis on making decisions about future activities. For the purpose of reporting
to outsiders, one year is the usual accounting period.
Stable Monetary Unit Concept. The Philippine peso is a reasonable unit of measure and that
its purchasing power is relatively stable. It allows accountants to add and subtract peso
amounts as though each peso has the same purchasing power as any other peso at any
time. This is the basis for ignoring the effects of inflation in the accounting records.
Going Concern Concept. Financial statements are normally prepared on the assumption
that the reporting entity is a going concern and will continue in operation for the foreseeable
future. Hence, it is assumed that the entity has neither the intention nor the need to enter
liquidation or to cease trading. This assumption underlies the depreciation of assets over their
useful lives.
• Assets, liabilities and equity – relate to a reporting entity’s financial position; and
• Income and expenses – relate to a reporting entity’s financial performance.
Financial Position
Asset
Asset is a present economic resource controlled by the entity as a result of past events. An
economic resource is a right that has the potential to produce economic benefits. There are
three aspects to these definitions: “right”; potential to produce economic benefits”; and
“control”.
Liability
Example:
a. Obligations to pay cash.
b. Obligations to deliver goods or provide services.
c. Obligations to exchange economic resources with another party on unfavorable
terms.
d. Obligations to transfer an economic resource if a specified uncertain future event
occurs.
e. Obligations to issue a financial instrument if that financial instrument will oblige the
entity to transfer an economic resource.
Equity
Equity is the residual interest in the assets of the enterprise after deducting all its liabilities. In
other words, they are claims against the entity that do not meet the definition of a liability.
Equity may pertain to any of the following depending on the form of business organization:
• In a sole proprietorship, there is only one owner’s equity account because there is only
one owner.
• In a partnership, an owner’s equity account exists for each partner.
• In a corporation, owners’ equity or stockholders’ equity consist of share capital,
retained earnings and reserves representing appropriations of retained earnings
among others.
Financial Performance
Income is increases in assets, or decreases in liabilities, that result in increases in equity, other
than those relating to contributions from holders of equity claims.
Expenses. Are decreases in assets, or increases in liabilities, that result in decrease in equity,
other than those relating to distributions to holders of equity claims.
THE ACCOUNT
The basic summary device of accounting is the account. A separate account is maintained
for each element that appears in the balance sheet (assets, liabilities and equity) and in the
income statement (income and expenses). Thus, an account may be defined as a detailed
record of the increases, decreases and balance of each element that appears in an entity’s
financial statements. The simplest form of the account is known as the “T” account because
of its similarity to the letter “T”. The account has three parts as follows.
Account Title
Debit Credit
side side
Left
side Right
Side
Financial statements tell us how a business is performing. They are the final products of the
accounting process. But how do we arrive at the items and amounts that make up the
financial statements? The most basic tool of accounting is the accounting equation. This
equation presents the resources controlled by the enterprise, the present obligations of the
enterprise and the residual interest in the assets. It states that assets must always equal
liabilities and owner’s equity. The basic accounting model is:
Note that the assets are on the left side of the equation opposite the liabilities and owner’s
equity. This explains why increases and decreases in assets are recorded in the opposite
manner (“mirror image”) as liabilities and owner’s equity are recorded. The equation also
explains why liabilities and owner’s equity follow the same rules of debit and credit.
Accounting is based on a double –entry bookkeeping system which means that the dual
effects of a business transaction is recorded. A debit side entry must have a corresponding
credit side entry. For every transaction, there must be one or more accounts debited and
one or more accounts credited. Each transaction affects at least two accounts. The total
debits for a transaction must always equal the total credits.
An account is debited when an amount is entered on the left side of the account and
credited when an amount is entered on the right side. The abbreviations for debit and credit
are DR. and CR respectively.
The account type determines how increases or decreases in it are recorded. Increases in
assets are recorded as debits while decreases in assets are recorded as credits. Conversely,
increases in liabilities and owner’s equity are recorded by credits and decreases are entered
as debits.
The rules of debit and credit for income and expense accounts are based on the relationship
of these accounts to owner’s equity. Income increases owner’s and expense decreases
owner’s equity. Hence, increases in income are recorded as credits and decreases as debits.
Increases in expenses are recorded as debits and decreases as credit. These are the rules of
debit and credit. The following summarizes the rules
The normal balance of any account refers to the side of the account- debit or credit-where
increases are recorded. Assets owner’s withdrawal and expense accounts normally have
debit balances; liability, owner’s equity and income accounts normally have credit balances.
This result occurs because increases in an account are usually greater than or equal to
decreases.
Increases Recoded by Normal Balance
Account Debit Credit Debit Credit
Assets X X
liabilities X X
Owner’s equity
Owner’s capital X X
Withdrawals X X
Income X X
expenses X X
Every accountable event has a dual but self-balancing effect on the accounting equation.
Recognizing these events will not in any manner affect the equality of the basic accounting
model. The four types of transactions above may be further expanded into nine types of
effects as follows:
1. Increase in Assets = Increase in Liabilities (SA)
2. Increase in Assets = Increase in Owner’s equity (SA)
3. Increase in in one = Decrease in another Asset (EA)
4. Decrease in Assets = Decrease in Liabilities (UA)
5. Decrease in Assets = Decrease in Owner’s Equity (UA)
6. Increase in Liabilities = Decrease in Owner’s equity (EC)
7. Increase in Owner’s equity = decrease in Liabilities (EC)
8. Increase in one Liability = Decrease in another liabilities (EC)
9. Increase in one Owner’s equity = Decrease in another Owner’s equity (EC)
ASSETS
Assets are should be classified only into two: current assets and non-current assets. Per revised
Philippine Standards (PAS) no. 1, an entity shall classify assets as current when:
a. It expects to realize the asset, or intends to sell or consume it, in its normal operating
cycle;
b. It holds the asset primarily for the purpose of trading;
c. It expects to realize the asset within twelve months after the reporting period; or
d. The asset is cash or a cash equivalents (as defined in PAS no. 7 ) unless the asset is
restricted from being exchanged or used to settle a liability for at least twelve
months after the reporting period.
All other assets should classified as non-current assets. Operating cycle is the time between
the acquisition of assets for processing and their realization in cash or cash equivalents. When
the entity’s normal operating cycle is not clearly identifiable, it is assumed to be twelve
months.
Current assets
Cash. Cash is any medium of exchange that a bank will accept for deposit at face value it
includes coins, currency, checks, money orders, bank deposits and drafts.
Cash equivalents. Per PAS no.7, these are short –term, highly liquid investments that are
readily convertible to known amounts of cash and which are subject to an insignificant risk of
changes in value.
Notes receivable. A note receivable is a written pledge that the customer will pay the
business a fixed amount of money on a certain date.
Accounts receivable. These are claims against customers arising from sale of services or
goods on credit. This type of receivable offers less security than a promissory note.
Inventories. Per PAS no. 2, these are assets which are (a) held for sale in the ordinary course
of business; (b) in the process of production for such sale; or (c) in the form of materials or
supplies to be consumed in the production process or in the rendering of services.
Prepaid expenses. These are expenses paid for by the business in advance. It is an asset
because the business avoids having to pay cash in the future for a specific expense. These
include insurance and rent. These prepaid items represent future economic benefits- assets
– until the time these start to contribute to the earning process; these, then, become
expenses.
Property, Plant, and Equipment. Per PAS no. 16, these are tangible assets that are held by an
enterprise for use in the production or supply of goods or services, or for rental to others, or for
administrative purposes and which are expected to be used during more than 1 period.
Included are such items as land, building, machinery and equipment, furniture and fixtures,
motor vehicles and equipment.
Accumulated depreciation. It is a contra assets account that contains the sum of the
periodic depreciation charges. The balance in this account is deducted from the cost of the
related assets- equipment or buildings – to obtain book value.
Intangible Assets. Per PAS no. 38. These are identifiable, nonmonetary assets without physical
substance held for use in the production or supply of goods or services, for rentals to others,
or for administrative purposes. These include goodwill, patents, copyrights, licenses,
franchises, trademarks, brand names, secret processes, subscription list, and non-competition
agreements.
Liabilities
Per revised Philippine Accounting Standards (PAS) no. 1, an entity shall classify a liability as
current when:
a. it expects to settle the liability in its normal operating cycle;
b. it holds the liability primarily for the purpose of trading;
c. the liability is due to be settled within twelve months after the reporting period; or
d. the entity does not have an unconditional right to defer settlement of the liability
for at least twelve months after the reporting period.
Current Liabilities
Accounts payable. This account represents the reverse relationship of the accounts
receivable. By accepting the goods or services, the buyer agrees to pay for them in the near
future.
Notes payable. A note payable is like a note receivable but in a reverse sense. In the case
of a note payable, the business entry is the maker of the note; that is, the business entity is the
party who promises to pay the other party a specified amount of money on a specified future
date.
Accrued Liabilities. Amounts owed to others for unpaid expenses. This account includes
salaries payable, utilities payable, interest payable and taxes payable.
Unearned Revenues. When the business entity receives payment before providing its
customers with goods or services, the amounts received are recorded in the unearned
revenue account (liability method). When the goods or services are provided to the
customer, the unearned revenue is reduced and income is recognized.
Current portion of long-term debt. These are portions of mortgage notes, bonds and other
long-term indebtedness which are to be paid within one year from the balance sheet date.
Mortgage Payable. This account records long-term debt of the business entity for which the
business entity has pledged certain assets as security to the creditor. In the event that the
debt payments are not made, the creditor can foreclose or cause the mortgaged asset to
be sold to enable the entity to settle the claim.
Bonds Payable. Business organization often obtain substantial sums of money from lenders to
finance the acquisition of equipment and other needed assets. They obtain these funds by
issuing bonds. The bond is a contract between the issuer and the lender specifying the terms
of repayment and the interest to be charged.
Owner’s Equity
Capital (from the Latin capitalis, meaning “property”). This account is used to record the
original and additional investments of the owner of the business entity. It is increased by the
amount of profit earned during the year or is decreased by a loss. Cash or other assets that
the owner may withdraw from the business ultimately reduce it. This account title bears the
name of the owner.
Withdrawals. When the owner of a business entity withdraws cash or other assets, such are
recorded in the drawing or withdrawal account rather than directly reducing the owner’s
equity account.
Income Summary. It is a temporary account used at the end of the accounting period to
close income and expenses. This account shows the profit or loss for the period before closing
to the capital accounts.
INCOME STATEMENT
Income
Service Income. Revenues earned by performing services for a customer or client; for
example, accounting services by a CPA firm, laundry shop.
Sales. Revenues earned as a result of sale of merchandise; for example, sale of building
materials by a construction supplies firm.
Expenses
Cost of sales. The cost incurred to purchase or to produce the products sold to customers
during the period; also called cost of goods sold.
Supplies expense. Expense of using supplies (e.g. office supplies) in the conduct of daily
business.
Depreciation expense. The portion of the cost of a tangible asset ( e.g. buildings and
equipment) allocated or charged as expense during an accounting period.
Accountants observe many events that they identify and measure in financial terms. A
business transaction is the occurrence of an event or a condition that affects financial
position and can be reliably recorded.
Every financial transaction can be analyzed or expressed in terms of its effects on the
accounting equation. The financial transactions will be analyzed by means of a financial
transaction worksheet which is a form used to analyze increases and decreases in the assets,
liabilities or owner’s equity of a business entity.
Illustration. Galicano Del Mundo decided to establish a sole proprietorship business and
named it as Del mundo Graphics Design. Del Mundo is a graphic designer who has extensive
experience in drawing, layout, typography, lettering, diagramming, and photography. He
possesses the talent to visually communicate to a target audience with the right combination
of words, images and ideas.
Del Mundo Graphics Design can do the layout and production design of newspapers,
magazines, corporate reports, journals and other publications. The entity can create
promotional displays; marketing brochures for services and product; packaging design for
products; and distinctive logos for businesses. He also enters into agreements with clients for
the progressive development and maintenance of their web sites. His initial revenue stream
comes from web designing.
The owner, Galicano Del Mundo, makes the business decisions. The assets of the company
belong to Del Mundo and all obligations of the business are his responsibility. Any income
that the entity earns belongs solely to Del Mundo.
When a specific asset, liability or owner’s equity item is created by a financial transaction, it
is listed in the financial transaction worksheet using the appropriate accounts. The worksheet
that follows shows the first transaction of the Del Mundo Graphics Design. The dates are
enclosed in parentheses.
During March 2019, the first month of operations, various financial transactions took place.
These transactions are described and analyzed as follows.
Mar. 1 Del Mundo started his new business by depositing P350,000 in a bank account
in the name of Del Mundo Graphics Design at BPI Poblacion Branch.
Del Mundo Graphics Design
Financial transaction worksheet
Month of March 2019
Mar. 5 Computer equipment costing P145,000 is acquired on cash. The effect of the
transaction on the basic equation is:
Assets = liabilities + Owner’s Equity
Cash + Computer Equip. Del Mundo, Capital
Bal. P350,000 P145,000 P350,000
(5) (145,000)
Bal. P205,000 + P145,000 = P350,000
======== ======== =======
This transaction did not change the total assets but it did change the
composition of the assets – it decreased one asset – cash and increased
another asset – computer equipment by P145,000. Note that the sums of the
balances on both sides of the equation are equal. This equality must always
exist.
Mar. 11 Del Mundo Graphics Design collected P88,000 in cash for designing interactive
web sites for two exporters based inside the Ortigas Ecozone.
Assets = Liabilities + Owner’s Equity
Cash + Computer + Computer = Accounts Del Mundo,
Supplies + equipment = payable Capital
Bal. P205,000+ P25,000 + P145,000 = P25,000 P350,000
(11) 88,000 88,000
Bal. P293,000 + P25,000 + P145,000 = P25,000 + P438,000
P463,000 = P463,000
======== ========
The entity earned service income by designing web sites for clients. Del Mundo
rendered his professional services and collected revenues in cash. The effect
on the accounting equation is an increase in the asset – cash and an increase
in owner’s equity. Income increases owner’s equity. This transaction caused
the business to grow, as shown by the increase in total assets from P375,000 to
P463,000.
Mar. 16 Del Mundo paid P18,000 to Ceradoy Bills Express, a one – stop bills payment
service company, for the semi-monthly utilities.
Assets = Liabilities + Owner’s Equity
Cash + computer + computer = accounts + Del Mundo,
Supplies equipment payable capital
Bal. P293,000 P25,000 P145,000 = P25,000 + P438,000
(16) (18,000) (18,000)
P275,000 + P25,000 + P145,000 = P25,000 + P420,000
P445,000 = P445,000
======== ========
Expenses are recorded when they are incurred. Expenses can be paid in cash
when they occur, or they can be paid later. The payment for utilities is an
expense for the month of March. It represented an outflow of resources and a
reduction of owner’s equity. Expenses have the opposite effect of income,
they cause the business to shrink as shown by the smaller amount of total assets
of P445,000.
Mar. 17 The entity has service agreements with several Netpreneurs to maintain and
update their web sites weekly. Del Mundo billed these clients P35,000 for
services already rendered during the month.
Assets = liabilities + Owner Equity
Cash + Accounts + Computer + Computer = Accounts + Del Mundo,
Receivables supplies equipment Payable capital
Bal. P275,000 P25,000 P145,000 P25,000 P420,000
(17) P35,000 = P35,000
P275,000 + P35,000+P25,000 + P145,000 = P25,000 + P455,000
P480,000 = P480,000
======== =======
The entity has performed services to clients so income should already be
recognized Del Mundo is entitled to receive payment for these but the clients
did not pay immediately. Performing the services creates an economic
resource, the client’s promise to pay the amount which is called accounts
receivable. This transaction resulted to an increase in asset- accounts
receivable and an increase in owner’s equity of P35,000.
Mar. 19 Del Mundo made a partial payment of P17,000 for the March 9 purchase on
account.
Assets = L + OE
Cash + accounts + computer + computer accounts + Del MUndo,
Receivable supplies equipment Payable capital
Bal. P275,000 P35,000 P25,000 P145,000 = P25,000 P455,000
(19) (17,000) (17,000
P258,000 +P35,000 + P25,000 + P145,000 = P 8,000 + P455,000
P463,000 = P463,000
========= ========
Mar. 20 Checks totaling P25,000 were received from clients for billing dated March 17.
A = l + OE
Cash + accounts + computer + computer = accounts + Del Mundo,
Receivable supplies equipment payable capital
Bal. P258,000 P35,000 P25,000 P145,000 = P8,000 P455,000
(20) 25,000 (25,000)
P283,000 +P10,000 + P25,000 + P145,000 = P8,000 + P455,000
P463,000 = P463,000
======== ========
Last March 17, Del Mundo billed clients for services already rendered. On
March 20, the entity was able to collect P25,000 from them. The asset-cash is
increased by P25,000. The business should not record service income on March
20 since it has already recorded the income last March 17. Total assets are
unchanged. The business merely reduced one asset – accounts receivable
and increased another –cash.
Mar. 21 Del Mundo withdrew P20,000 from the business for his personal use.
A = L + OE
Cash + accounts + computer + computer = Accounts + Del Mundo,
Receivables supplies equipment = Payable + capital
Bal. P283,000 P10,000 P25,000 P145,000 P8,000 P455,000
(21) (20,000) = (20,000)
P263,000 + P10,000 + P25,000 + P145,000 = P8,000 + P435,000
P443,000 = P443,000
========= = ========
Withdrawal of cash or other assets for personal use is the by which the owner
of the entity receives advance distribution of the profits. On March 1, Del
Mundo invested P350,000; both cash and owner’s equity increased. The
transaction was an investment by the owner and not an income-generating
activity. Del Mundo simply transferred funds from his personal account to the
business. A cash withdrawal is exactly the opposite. The P20,000 cash
withdrawal transaction resulted to a reduction in both cash and owner’s
equity.
Mar. 27 Warlito Blance Publishing submitted a bill to Del Mundo for P8,000 worth of
newspaper advertisements for this month. Del Mundo will pay this bill next
month.
A = L + OE
Cash + accounts + Computer + computer = Accounts + Del Mundo,
Receivable supplies equipment = payable capital
Bal. P263,000 P10,000 P25,000 P145,000 = P8,000 P435,000
(27) = P8,000 (P8,000)
P263,000 + P10,000 + P25,000 + P145,000 = P16,000 + P427,000
P443,000 = P443,000
======== ========
Warlito Blance rendered services on account. Del Mundo Graphics Design has
incurred an expense in the amount of P8,000 by availing of Warlito Blance’s
services. There was no payment during the month. This advertising expense
resulted to a decrease in owner’s equity and an increase in the liability –
accounts payable.
Mar. 31 Del Mundo paid his assistant designer salaries of P15,000 for the month.
A = L + OE
Cash + accounts + computer + computer = accounts Del Mundo,
Receivables supplies equipment payable capital
Bal. P263,000 P10,000 P25,000 P145,000 = P16,000 P427,000
(31) (15,000) = (15,000)
P248,000 + P10,000 + P25,000 + P145,000 = P16,000 + P412,000
P428,000 = P428,000
======== ========
Multiple Choice
1. If assets total P700,000 and liabilities total P400,000, how much are the net
assets?
a. P300,000
b. P400,000
c. P700,000
d. P1,100,000
2. What are increases in resources that a firm earns by providing goods or services
to its customers?
a. Assets
b. Income
c. Expenses
d. Liabilities
3. If assets increase by P100,000 and Liabilities decrease by P30,000, owner’s
equity must
a. remained unchanged
b. increase by P130,000
c. decrease by P70,000
d. decrease by P130,000
4. Which of the following is true?
a. The debit is on the right side of an asset account.
b. The debit is on the left side of an asset account.
c. The credit is on the left side of a liabilities account.
d. The debit is on the right side of an expense account.
5. Which of the following accounts has a normal debit balance?
a. Accounts payable
b. Notes payable
c. Consulting revenues
d. Advertising expense
Learning Objectives:
After studying this chapter, you should be able to:
1. List and explain in brief the sequential steps in the accounting cycle.
2. Identify the general journal as the book of original entry.
3. Detail the standard contents of the general journal.
4. Outline the steps in analyzing transactions and state the role of
source documents.
5. Analyze the impact of transactions on the elements and the specific
accounts.
6. Apply the rules of debits and credits in analyzing business
transactions.
7. Journalize transactions in proper form.
8. Describe a general ledger and understand what purpose it serves.
9. Post entries from the general journal to the general ledger.
10. Distinguish between permanent and temporary accounts.
11. Develop a chart of account.
12. Prepare and explain the use of a trial balance.
SOURCE DOCUMENTS
Transactions and events are the starting points in the accounting cycle. By relying on source
documents, transaction s and events can be analyzed as to how they will affect performance
and financial position. Source documents identify and describe transactions and events
entering the accounting process. These original written evidences contain information about
the nature and the amounts of the transactions. These are the bases for the journal entries;
some of the more common source documents are sales invoices, cash register tapes, official
receipts, bank deposit slips, bank statements, checks, purchase orders, time cards and
statements of account.
ACCOUNTING CYCLE
This cycle is repeated each accounting period. The first three steps in the accounting cycle
are accomplished during the period. The fourth to the ninth steps generally occur at the end
of the period. The last step is optional and occurs at the beginning of the next period.
THE JOURNAL
The journal is a chronological record of the entity’s transactions. A journal entry shows all the
effects of a business transaction in terms of debits and credits. Each transaction is initially
recorded in a journal rather than directly in the ledger. A journal is called the book of original
entry. The nature and volume of transactions of the business determine the number and type
of journals needed. The general journal is the simplest journal.
Format
The standard contents of the general journal are as follows:
1. Date. The year and month are not rewritten for every entry unless the year or month
changes or a new page is needed.
2. Account titles and explanation. The account to be debited is entered at the extreme
left of the first line while the account to be credited is entered slightly indented on the
next line. A brief description of the transaction is usually made on the line below the
credit. Generally, skip a line after each entry.
3. P. R. (posting reference). This will be used when the entries are posted, that is, until the
amounts are transferred to the related ledger accounts. The posting process will be
described later.
4. Debit. The debit amount for each account is entered in this column.
5. Credit. The credit amount for each account is entered in this column.
Assume that Maria Concepcion Jennifer Perez-Manalo established her own wedding
consultancy with an initial investment of P250,000 on May 1
After the transaction or event has been identified and measured, it is recorded in the journal.
The process of recording a transaction is called journalizing. The following are the transactions
for Wedding “R” Us during the month of May. The double – entry system will be used.
To understand the nature of the affected accounts, the letter A (for asset), L (liability) or OE
(owner’s Equity) is inserted after each entry. In addition, owner’s equity is further classified
into OE: I (income) and OE: E (expenses)
Note that the rule of double – entry system are observed in each transaction:
1. Two or more accounts are affected by each transaction.
2. The sum of the debits for every transaction equals the sum of the credits.
3. The equality of the accounting equation is always maintained.
May 2 Hired an office assistant and an account executive each with a P7,800 monthly
salary. Or, each is to receive P300 per day for the 26-day work month. No entry
is necessary at this point. They started work immediately.
Debit Credit
Service vehicle(A) 420,000
Cash (A) 420,000
May 4 Paid Prudential Guarantee and Assurance, Inc. P14,400 for a one-year
comprehensive insurance coverage on the service vehicle.
May 8 Purchased supplies on credit for P18,000 from San Jose merchandising.
May 10 Coordinated and finalized simple bridal arrangements for three couples and
collected fees of P8,800 per couple. Services include prospecting and
selecting the church and reception location, couturier, caterer, car service,
flowers, souvenirs, and invitations.
Analysis Assets increased. Owner’s equity increased.
Entry Increase in assets is recorded by a debit to cash. Increase in owner’s equity is
recorded by a credit to consulting revenues.
Debit Credit
Cash (A) 26,400
Consulting revenues (OE:I) 26,400
May 13 Paid salaries, P6,600. The entity pays salaries every two Saturdays
Debit Credit
May 19 Coordinated and finalized elaborate bridal arrangements for three couples
and billed fees of P12,000 per couple. Additional services include documents
preparation, consultation with a feng shui expert as to the ideal wedding date
for prosperity and harmony, provision for limousine service and honeymoon
trip.
Analysis Assets increased. Owner’s equity increased.
May 30 Received P24,000 from two clients for services billed last May 19.
THE LEDGER
A grouping of the entity’s accounts is referred to as ledger. Although some firms may use
various ledgers to accumulate certain detailed information, all firms have a general ledger.
A general ledger is the “reference book” of the accounting system and is used to classify and
summarize transactions, and to prepare data for basic financial statements
The accounts in the general ledger are classified into two general groups:
1. Balance sheet or permanent accounts (assets, liabilities and owner’s equity).
2. Income statement or temporary accounts (income and expenses). Temporary or
nominal accounts are used to gather information for a particular accounting period.
At the end of the period, the balances of these accounts are transferred to a
permanent owner’s equity account.
Each account has its own record in the ledger. Every account in the ledger maintains the
basic format of the T-account but offers more information (e.g. the account number at the
upper right corner and the journal reference column). Compared to a journal, a ledger
organizes information by account.
CHART OF ACCOUNTS
A listing of all the accounts and their account numbers in the ledger is known as the chart of
accounts. The chart is arranged in the financial statement order, that is, assets first, followed
by liabilities, owner’s equity, income and expenses. The accounts should be numbered in a
flexible manner to permit indexing and cross-referencing.
When analyzing transactions, the accountant refers to the chart of accounts to identify the
pertinent accounts to be increased or decreased. If an appropriate account title is not listed
in the chart, an additional account may be added. Presented below is the chart of accounts
for the illustration.
Wedding “R” Us
Chart of Accounts
POSTING (STEP 3)
Posting means transferring the amounts from the journal to the appropriate accounts in the
ledger. Debits in the journal are posted as debits in the ledger, and credits in the journal as
credits in the ledger. The steps are illustrated as follows:
1. Transfer the date of the transaction from the journal to the ledger.
2. Transfer the page number from the journal to the journal reference (J.R.) column of
the ledger.
3. Post the debit figure from the journal as a debit figure in the ledger and the credit
figure from the journal as a credit figure in the ledger.
4. Enter the account number in the posting reference column of the journal once the
figure has been posted to the ledger.
The Journal
The Ledger
The trial balance is a list of all accounts with their respective debit or credit balances. It is
prepared to verify the equality of debits and credits in the ledger at the end of each
accounting period or at any time the posting are updated.
The trial balance is a control device that helps minimize accounting errors. When the totals
are equal, the trial balance is in balance. This equality provides an interim proof of the
accuracy of the records but it does not signify the absence of errors. For example, if the
bookkeeper failed to record payment of rent, the trial balance columns are equal but in
reality, the accounts are incorrect since rent expense is understated and cash overstated.
An inequality in the totals of the debits and credits would automatically signal the presence
of an error. These errors include:
1. Error in posting a transaction to the ledger:
a. An erroneous amount was posted to the account.
b. A debit entry was posted as a credit or vice versa.
c. A debit or credit posting was omitted.
2. Error in determining the account balances:
a. A balance was incorrectly computed
b. A balance was entered in the wrong balance column.
3. Error in preparing the trial balance:
a. One of the columns of the trial balance was incorrectly added.
b. The amount of an account balance was incorrectly recorded on the trial
balance.
c. A debit balance was recorded on the trial balance as a credit or vice versa,
or a balance was omitted entirely.
What is the most efficient approach in locating an error? The following procedures when
done in sequence may save considerable time and effort in locating errors:
1. Prove the addition of the trial balance columns by adding these columns in the
opposite direction.
2. If the error does not lie in addition, determine the exact amount by which the trial
balance is out of balance. The amount of the discrepancy is often a clue to the
source of the error. If the discrepancy is divisible by 9, this suggests either a
transposition (reversing the order of numbers) error or a slide (moving of the decimal
point). For example, assume that the cash account balance is P21,750, but in copying
the balance into the trial balance the figures are transposed and written as P21, 570.
The resulting error amounted to P180 and is divisible by 9. Another common error is
the slide, or incorrect placement of the decimal point, as when P21,750.00 is copied
as P2,175.00. The resulting discrepancy in the trial balance will also be an amount
divisible by 9.
Assume that the office equipment account has a debit balance of P42,000 but it is
erroneously listed in the credit column of the trial balance. This will cause a
discrepancy of two times P42,000 or P84,000 in the trial balance totals. Since such
errors as recording a debit in a credit column are common, it is advisable, after
determining the discrepancy in the trial balance totals, to scan the columns for an
amount equal to exactly one-half of the discrepancy. It is also advisable to look over
the transactions for an item of the exact amount of the discrepancy. An error may
have been made by recording the debit side of the transaction and forgetting to
enter the credit side.
3. Compare the accounts and amounts in the trial balance with that in the ledger. Be
certain that no account is omitted.
4. Recompute the balance of each ledger account.
5. Trace all posting from the journal to the ledger accounts. As this is done, place a
check mark in the journal and in the ledger after each figure is verified. When the
operation is completed, look through the journal and the ledger for unchecked
amounts. In tracing postings, be alert not only for errors in amount but also for debits
entered as credits, or vice versa.
Note that even when a trial balance is in balance, the accounting records may still
contain errors. A balanced trial balance simply proves that, as recorded, debits equal
credits. The following errors are not detected by a trial balance.
1. Failure to record or post a transaction.
2. Recording the same transaction more than once.
3. Recording an entry but with the same erroneous debit and credit amounts.
4. Posting a part of a transaction correctly as debit or credit but to the wrong account.
Multiple Choice
EVALUATION: Quiz
Learning Objectives:
ACCRUAL BASIS
The financial statements, except for the cash flow statement, are prepared on the accrual
basis of accounting in order to meet their objectives. Under the accrual basis, the effects of
transactions and other events are recognized when they occur and not as cash is received
or paid. This means that the accountant records revenues as they are earned and expenses
as they are incurred. The timing of cash flows is relatively immaterial for determining when to
recognize revenues and expenses.
PERIODICITY CONCEPT
The only way to know how successfully a business has operated is to close its doors, sell all its
assets, pay the liabilities and return any excess cash to the owners. This process of going out
of business is called liquidation. This, however, is not a practical way of measuring business
performance.
Accounting periods are generally a month, a quarter or a year. The most basic accounting
period is one year. Entities differ in their choice of the accounting year- fiscal, calendar or
natural. A fiscal year is a period of any twelve consecutive months. A calendar year is an
annual period ended December 31. A natural business year is a twelve-month period that
ends when business activities are at their lowest level of the annual cycle. A period of less
than a year is an interim period. Some even adopt an annual reporting period of 52 weeks.
Businesses need periodic reports to assess their financial condition and performance. The
periodicity concept ensures that accounting information is reported at regular intervals. It
interacts with the recognition and derecognition principles to underlie the use of accruals.
To measure profit in a fair manner, entities update the income and expense-accounts
immediately before the end of the period.
The initial recognition of assets or liabilities arising from transactions or other events may result
in the simultaneous recognition of both income and related expenses. For example, the sale
of goods for cash results in the recognition of both income (from the recognition of one asset-
the cash) and an expense (from the derecognition of another asset- the goods sold). The
simultaneous recognition of income and related expenses is sometimes referred to as the
matching of costs with income.
Derecogntion is the removal of all or part of a recognized asset or liability from an entity’s
statement of financial position. Derecognition normally occurs when that item no longer
meets the definition of an asset or a liability.
a. For an asset, derecogntion normally occurs when the entity losses control of all
or part of the recognized asset; and
b. For a liability, derecognition normally occurs when the entity no longer has a
present obligation for all or part of the recognized liability.
In short, adjustments are needed to ensure that the recognition and derecognition principles
are followed thus resulting to financial statements reporting the effects of all transactions at
the end of the period.
Adjusting entries involve charging account balances at the end of the period from what is
the current balance of the account to what is the correct balance for proper financial
reporting. Without adjusting entries, financial statements may not fairly show the solvency of
the entity in the balance sheet and the profitability in the income statement.
Accountants use adjusting entries to apply accrual accounting to transactions that cover
more than one accounting period. There are two general types of adjustments made at the
end of the accounting period –deferrals and accruals.
Each adjusting entry affects a balance sheet account (an asset or a liability account) and
an income statement account (income or expense account).
Deferral is the postponement of the recognition of “an expense already paid but not yet
incurred, “ or of “ revenue already collected but not yet earned”. This adjustment deals with
an amount already recorded in a balance sheet account; the entry, in effect, decreases the
balance sheet account and increases an income statement account. Deferrals would be
needed in two cases:
1. Allocating assets to expense to reflect expenses incurred during the accounting
period (e.g. prepaid insurance, supplies and depreciation).
2. Allocating revenues received in advance to revenue to reflect revenues earned
during the accounting period (e.g. subscriptions).
Accrual is the recognition of “an expense already incurred but unpaid”, or “revenue earned
but uncollected”. This adjustment deals with an amount unrecorded in any account; the
entry, in effect, increase both a balance sheet and an income statement account. Accruals
would be required in two cases:
1. Accruing expenses to reflect expenses incurred during the accounting period that are
unpaid and unrecorded.
2. Accruing revenues to reflect revenues earned during the accounting period that are
uncollected and unrecorded.
The weddings “R” Us case is continued to illustrate the adjustment process. The letters A, L,
OE, OE:I and OE:E are still used to ensure a better understanding of the nature of the accounts
affected.
Entities often make expenditures that benefit more than one period. These expenditures are
generally debited to an asset account. At the end of each accounting period, the estimated
amount that has expired during the period or that has benefited the period is transferred from
the asset account to an expense account. Two of the more important kinds of adjustments
are prepaid expenses, and depreciation of property and equipment.
Prepaid Expenses
Some expenses are customarily paid in advance. These expenditures (e.g. supplies, rent and
insurance) are called prepaid expenses. Prepaid expenses are assets, not expenses. At the
end of an accounting period, a portion or all of these prepayments may have expire. The
portion of an asset that has expired becomes an expense. Prepaid expenses expire either
with the passage of time or through use and consumption. The flow of costs from the balance
sheet to the income statement is illustrated below:
If adjustment for prepaid expenses are not made at the end of the period, both the balance
sheet and the income statement will be misstated. First, the assets of the entity will be
overstated; second, the expenses of the company will be understated. For this reason,
owner’s equity in the balance sheet and profit in the income statement will both be
overstated. Besides prepaid rent, Wedding “R” Us has prepaid expenses for supplies and
insurance, both accounts need adjusting entries.
Prepaid Rent (adjustment a). On May 1, Weddings “R” Us paid P8,000 for two months’ rent in
advance. This expenditure resulted to an asset consisting of the right to occupy the office for
two months. A portion of the asset expires and becomes an expense each day. By May 31,
one –half of the asset had expired, and should be treated as an expense.
The analysis of this economic event is shown below.
Prepaid Insurance (adl. b). Weddings “R” Us acquired a one-year comprehensive insurance
coverage on the service vehicle and paid P14,400 premiums. In a manner similar to prepaid
rent, prepaid insurance offers protection that expires daily. The adjustment is analyzed and
recorded as shown below:
Supplies (adjustment c). On May 8, Weddings “R” Us purchased supplies, P18,000. During the
month, the entity used supplies in the process of performing services for clients. There is no
need to account for these supplies every day since the financial statements will not be
prepared until the end of the month. At the end of the accounting period, Perez-Manalo
makes a careful physical inventory of the supplies. The inventory count showed that supplies
costing P15,000 are still on hand. This transaction is analyzed and recorded as follows:
When an entity acquires long-lived assets such as buildings, service vehicles, computers or
office furnitures, it is basically buying or preparing for the usefulness of that asset. These assets
help generate income for the entity. Therefore, a portion of the cost of the assets should be
reported as expense in each accounting period. Proper accounting requires the allocation
of the cost of the asset over its estimated useful life. The estimated amount allocated to any
one accounting period is called depreciation or depreciation expenses. Three factors are
involved in computing depreciation expense.
1. Asset cost is the amount an entity paid to acquire the depreciable asset.
2. Estimated salvage value is the amount that the asset can probably be sold for at the
end of its estimated useful life.
3. Estimated useful life is the estimated number of periods that an entity can make use
of the asset. Useful life is an estimate, not an exact measurement.
The asset account is not directly reduced when recording depreciation expense. Instead,
the reduction is recorded in a contrac account called accumulated depreciation. A contra
account is used to record reductions in a related account and its normal balance is opposite
that of the related account. Use of the contra account – accumulated depreciation – allows
the disclosure of the original cost of the related asset in the balance sheet. The balance of
the contra account is deducted from the cost to obtain the book value of the property and
equipment.
Service Vehicle and Office Equipment (adjs. D and e). Suppose that Weddings “R” Us
estimated that the service vehicle, which was bought on May 4, will last for seven years
(eighty-four months) and with a salvage value of P84,000. The office equipment that was
acquired on May 5 will have a useful life of five years (sixty months) and will be worthless at
that time. Substitution of the pertinent amounts into the basic formula will yield depreciation
for service vehicle and office equipment for the month as P4,000 (420,000-84,000)/84months
and P1,000 (P60,000/60 months), respectively. These amounts represent the cost allocated
to the month, thus reducing the asset accounts and increasing the expense accounts. As a
matter of company policy, the period May 4 to 31 is considered a month. The analysis follows;
There are times when an entity receives cash for services or goods even before service is
Rendered or goods are delivered. When such is received in advance, the entity has an
Obligation to perform services or deliver goods. The liability referred to is unearned revenues.
For example, publishing companies usually receive payments for magazine subscriptions in
Advance. These payments must be recorded in a liability account. If the company fails to
Deliver the magazines for the subscription period, subscribers are entitled to a refund. As the
Company delivers each issue of the magazine, it earns a part of the advance payments. This
Earned portion must be transferred from the unearned subscription revenues account to the
Subscription revenue account.
Unearned Referral Revenues (adj. f). On May 15, Weddings “R” Us received P10,000 as an
advance payment for referrals made. Assume that by the end of the
month, one of the three couples referred has already taken their
marriage vows and as a result the amount of P4,000 pertaining to the
referred event has been realized. This transaction is analyzed as follows:
The liability account unearned referral revenues reflects the referral revenues still to be
earned, P6,000. The referral revenues account reflects the amount of
referrals already completed and considered as revenues during the
months, P4,000.
Accrued Expenses
An entity often incurs expenses before paying for them. Cash payments are usually made at
regular intervals of time such as weekly, monthly, quarterly or annually.
If the accounting period ends on a date that does not coincide with
the schedule cash payment date, an adjusting entry is needed to
reflect the expense incurred since the last payment. This adjustment
helps the entity avoid the impractical preparation of hourly or daily
journal entries just to accrue expenses. Salaries, interest, utilities (e.g. ,
electricity, telecommunications and water) and taxes are examples of
expenses that are incurred before payment is made.
Accrued Salaries (adj. g). Entities pay their employees at regular intervals. It can be weekly,
semi-monthly or monthly. Weekly payrolls are usually made on Fridays
(for a five-day workweek) or Saturdays (for a six-day workweek).
Weddings “R” Us pays salaries every two Saturdays. Assume that the
calendar for May appears as follows:
May
Su M T W Th F Sa
1 2 3 4 5 6
7 8 9 10 11 12 13
14 15 16 17 18 19 20
21 22 23 24 25 26 27
28 29 30 31
The office assistant and the account executive were paid salaries on May 13 and 27. At
month-end, the employees have worked for three days (May 29, 30 and
31) beyond the last pay period. The employees earned the salary for
these days, but it is not due to be paid until the regular payday in April.
The salary for these three days is rightfully an expense for May, and the
liabilities should reflect that the entity owes the employees salaries for
those days.
Each of the employee’s salary rate is P7,800 per month or P300 per day (P7,800/26 working
days). The expense to be accrued is P1,800 (P300 x 3 days x
employees). This accrued expense can be analyzed as shown:
The liability of P1,800 is now correctly reflected in the salaries payable account. The actual
expense incurred for salaries during the month is P15,600.
Accrued Interest (adj. h). On May, Perez-Manalo borrowed P210,000 from Metrobank. She
issued a promissory note that carried a 20% interest per annum. Both
the interest and principal will be payable in one year. The note issued
to the bank accrued interest at 20% annually. At the end of May, Perez-
Manalo owed the bank P3,500 (see computation below) for interest in
addition to the P210,000 loan. Interest is a charge for the use of money
over time. Interest expense is matched to a particular period during
which the benefit – the use of borrowed money – is received. The
interest is a fixed obligation and accrues regardless of the result of the
entity’s operations.
Interest rates are expressed at annual rates, so if interest is being calculated for less than a
year, the calculation must express time as a portion of a year. Thus, the
interest expense (simple) incurred on this note during the month is
determined by the following formula:
Interest = Principal x Interest Rate x Length of time
= P210,000 x 20% per year x 1/12 of a year
= P210,000 x .20 x 1/12
= P3,500
The adjusting entry to record the interest expense incurred in May is as follows:
Accrued Revenues
An entity may provide services during the period that are neither paid for by clients nor billed
at the end of the period. The value of these services represents revenue
earned by the entity. Any revenue that has been earned but not
recorded during the accounting period calls for an adjusting entry that
debits as asset account and credits an income account.
Accrued Consulting revenues (adj, i). Suppose that Weddings “R” Us agreed to arrange a
rush but simple civil wedding for a madly in love couple in the afternoon
of May 31. The entity intended to charge fees of P5,300 for the services,
which is earned but unbilled. This should be recorded as shown below:
A total of P67,700 in consulting revenues was earned by the entity during the month.
The weddings “R” Us illustration did not tackle entries related to uncollectible accounts.
Hence, the ensuing discussion on the accrual of uncollectible accounts
is not in any way related to the Weddings “R” Us illustration. This is to
complete the illustrations on adjustment for accruals.
Entities often allow clients to purchase goods or avail of services on credit. Some of these
accounts will never be collected; hence, is a need to reflect these as
charges against income. In practice, an expense is recognized for the
estimated uncollectible accounts in the period, rather than when
specific accounts actually become uncollectible. This practice
produces a better matching of income and expenses. Estimates of
uncollectible accounts may be based on credit sales for the period or
on the accounts receivable balance.
Assume that an entity made credit sales of P1,100,000 in 2019 and prior experience indicates
an expected 1% average uncollectible accounts rate based on credit
sales. The contra account-allowance for uncollectible accounts has a
normal credit balance and is shown in the balance sheet as a
deduction from Accounts receivable. The allowance account need to
be increased by P11,000 (P1,100,000 x 1%) because accounts
receivables in that amount is doubtful of collection. The adjustment will
be:
Debit Credit
Uncollectible accounts Expense (OE:E) 11,000
Allowance for Uncollectible Accounts (A) 11,000
Throughout the accounting period, when there is positive evidence that a specific account
is definitely uncollectible, the appropriate amount is written off against
the contra account. For example, if a P1,500 receivable were
considered uncollectible, that amount would be written off as follows:
Debit Credit
Allowance for uncollectible accounts (A) 1,500
Accounts receivable 1,500
No entry is made to uncollectible accounts expense, since the adjusting entry has already
provided for an estimated expense based on previous experience for
all receivables.
Multiple Choice
EVALUATION: Quiz
Learning Objectives:
1. Describe the flow of accounting information from the unadjusted trial balance into
the adjusted trial balance and finally, who the income statement and balance sheet
columns of the worksheet.
2. Prepare accurately an in good form a ten column worksheet.
3. Understand and appreciate the usefulness of financial statements.
4. Develop skills in the preparation of financial statements.
5. Explain how the financial statements are interrelated.
THE WORKSHEET
Accountants often use a worksheet to help transfer data from the unadjusted trial balance
to the financial statements. This multi-column document provides an efficient way to
summarize the data for financial statements. The accountant generally prepares a
worksheet when it is time to adjust the accounts and prepare financial statements. Note,
however, that it is possible to prepare financial statements directly from the adjusted trial
balance at the end of the accounting period if the business has relatively few accounts.
The worksheet simplifies the adjusting and closing process. It can also reveals errors. The work
sheet is not part of the ledger or the journal, nor is it a financial statement. It is a summary
device used by the accountant for his convenience.
The steps in the preparation of a worksheet will be illustrated using the Wedding “R” Us case:
1. Enter the account balances in the unadjusted trial balance columns and total the
amounts.
The numbers, titles and balances of the accounts as at May 31 are lifted directly from
the ledger before the adjusting entries are prepared. The accounts are listed in the
worksheet in the order they appear in the ledger. Total debits must equal total credits,
as shown in Exhibit 4-1. Accounts with zero balances (e.g., salaries payable, interest
payable, etc.) are also presented. Listing all the accounts with their balances helps
identify the accounts that need adjustments. This practice will help ensure the
achievement of completeness and accuracy in the adjustment process.
2. Enter the adjusting entries in the adjustment columns and total the amounts.
When a worksheet is used, all adjustments are first entered in the worksheet. The
required adjustments for Weddings “R” Us were explained in the previous chapter. The
same adjustments are entered in the adjustments columns of the worksheet in Exhibit
4-2. As each adjustment is entered, a letter is used to identify the debit entry and the
corresponding credit entry. Note that the adjustments are not journalized until after
the worksheet is completed and the financial statements prepared.
3. Compute each account’s adjusted balance by combining the unadjusted trial
balance and the adjustment figures. Enter the adjusted amounts in the adjusted trial
balance columns.
Exhibit 4-3 exhibited the adjusted trial balance prepared by combining horizontally,
line by line, the amount of each account in the unadjusted trial balance columns with
the corresponding amounts in the adjustment columns. This procedure is called cross-
footing. To illustrate, the first line showed cash with a debit amount of P22,200 in the
unadjusted trial balance. There is no adjustment to the cash account so that the
P22,200 is entered in the debit column of the adjusted trial balance. On the second
line is accounts receivable with a P12,000 balance in the unadjusted trial balance; a
debit of P5,300 is entered in the adjustments columns. The resulting balance is a
P17,300 debit in the adjusted trial balance.
Supplies, on the third line, showed a debit of P18,000 in the unadjusted trial balance
columns and a credit of P3,000 in the adjustments columns. The P3,000 credit is
subtracted from the P18,000 debit; the result is a P15,000 debit in the adjusted trial
balance. Consulting revenues, on the nineteenth line, reported a P62,400 credit in the
unadjusted trial balance and a P5,300 credit in the adjustments columns. These two
credit amounts are added, and the P67,700 sum is entered in the credit column of the
adjusted trial balance. This process is followed through all the accounts. The adjusted
trial balance columns are then totaled to check the accuracy of the cross-footing.
A simple convention to observe when extending amounts from the trial balance to
the adjusted trial balance follows:
• Add when the type of adjustment (debit or credit) is the same as the unadjusted
balance.
• Subtract when the type of adjustment (debit or credit) is different from the unadjusted
balance.
4. Extend the asset, liability and owner’s equity amounts from the adjusted trial balance
columns to the balance sheet columns. Extend the income and expense amounts to
the income statement columns. Total the statement columns.
The profit figure is extended to the credit column of the balance sheet because profit
increases owner’s equity are recorded as credits. Observe that the capital account
amount of P250,000 shown in the worksheet reflects the beginning rather than the
ending balance. Profit must be added and withdrawals subtracted to arrive at the
ending capital balance; this is done when the statement of changes in equity is
prepared.
There are questions that the owner of a business periodically asks – how much did the business
entity earn? What is the financial condition of the business? How much is the owner’s interest
in the entity today? What happened to the cash receipts? Where did cash go? Investors,
creditors, taxing authorities and other users have their own questions about the business which
need to be answered.
The financial statements are the means by which the information accumulated and
processed in financial accounting is periodically communicated to the users. Without
accounting information embodied in the financial statements, users may not be able to arrive
at sound economic decisions.
Per March 2018 Conceptual framework for Financial Reporting (2018 conceptual framework),
the objective of financial statements is to provide financial information about the reporting
entity’s assets, liabilities, equity, income and expenses that is useful to users of financial
statements in assessing the prospects for future net cash inflows to the reporting entity and in
assessing management’s stewardship of the entity’s economic resources.
In a nutshell, the statement of financial position (or balance sheet) lists all the assets, liabilities
and equity of an entity as at a specific date. The statement of financial performance (or
income statement) presents a summary of the revenues and expenses of an entity for a
specific period. The statement of changes in equity presents a summary of the changes in
capital such as investments, profit or loss, and withdrawals during a specific period. The
statement of cash flows reports the amount of cash received and disbursed during the
period. Accounting policies are the specific principles, bases, conventions, rules and
practices adopted by an enterprise in preparing and presenting financial statements. Notes
to financial statements provide narrative description or disaggregation of items presented in
the statements and information about items that do not qualify for recognition in the
statements.
Once the worksheet is completed, it is easy to prepare the financial statements for the
account balances have been extended to the appropriate income statement and balance
sheet columns. Most of the information needed to prepare the income statement, statement
of changes in equity and balance sheet are available from the worksheet. The statements
presented are those of Weddings “R” Us. Note that financial statements shall be presented
at least annually (per revised PAS no. 1)
An entity can present all items of income and expense recognized in a period: in a single
statement of comprehensive income, or in two statements: a statement displaying
components of profit or loss (separate income statement) and a second statement
beginning with profit or loss and displaying components of other comprehensive income.
However, the 2018 conceptual framework does not specify whether the statement of
financial performance comprises a single statement or two statements.
The income statement is a statement showing the performance of the enterprise for a given
period of time. It summarizes the revenues earned and expenses incurred for that period of
time. The income statement for Weddings “R” Us (refer to exhibit 4-5) is prepared directly
from the income statement columns of the worksheet in exhibit 4-4.
Weddings “R” Us
Income Statement
For the month ended May 31, 2019
Revenues
Consulting Revenues P67,700
Referral Revenues 4,000
Total P71,700
Expenses
Salaries expense P15,600
Utilities expense 4,400
Rent expense 4,000
Depreciation expense –service vehicle 4,000
Interest expense 3,500
Supplies expense 3,000
Insurance expense 1,200
Depreciation expense – office equipment 1,000
Total 36,700
Profit P35,000
=======
The statement of changes in equity summarizes the changes that occurred in owner’s equity.
This statement is now a required statement (per revised Philippine Accounting Standards
(PAS) no.1). Changes in an enterprise’s equity between two balance sheet dates reflect the
increase or decrease in its net assets during the period.
In the case of sole proprietorships, increases in owner’s equity arise from additional
investments by the owner and profit during the period. Decreases result from withdrawals by
the owner and from loss for the period. The beginning balance and additional investments
are taken from the owner’s capital account in the general ledger. The profit or loss figure
comes directly from the income statement while the withdrawals from the balance sheet
columns in the worksheet.
Weddings “R” Us
Statement of Changes in Equity
For the month ended May 31, 2019
The statement of financial position is a statement that shows the financial position or condition
of an entity by listing the assets, liabilities and owner’s equity as at a specific date. The
information needed for this statement are the net balances at the end of the period, rather
than the total for the period as in the income statement. This statement is also called the
balance sheet.
Users of financial statements analyze the balance sheet to evaluate an entity’s liquidity, its
financial flexibility, and its ability to generate profits, and its solvency. Liquidity refers to the
availability of cash in the near future after taking account of the financial commitments over
this period. Financial flexibility is the ability to take effective actions to alter the amounts and
timings of cash flows so that it can respond to expected needs and opportunities. This
includes the ability to raise new capital or tap into unused lines of credit. Solvency refers to
the availability of cash over the longer term to meet financial commitments as they fall due.
In preparing the balance sheet, it may not be necessary to make any further analysis of the
data. The needed data – that is, the balances of the asset, liability, and owner’s equity
accounts- are already available from the balance sheet columns of the worksheet. However,
the interim balance for owner’s equity must be revised to include profit or loss and owner’s
withdrawals for the accounting period. The adjusted amount for ending owner’s equity is
shown in the statement of changes in equity.
Format
The balance sheet can be presented in either the report format or the account format. The
report format simply lists the assets, followed by the liabilities then by the owner’s equity in
vertical sequence. The account format lists the assets on the left and the liabilities and
owner’s equity on the right. Either balance sheet format is acceptable.
Classification
The revised PAS no. 1 does not prescribe the order or format in which an entity presents items
in the statement of financial position; what is required is the current and non-current
distinction for assets and liabilities. Assets can be presented current then non-current, or vise
versa. Liabilities and equity can be presented current liabilities then non-current liabilities then
equity, or vice versa.
It is proper to present a classified balance sheet; that is, the assets and liabilities are separated
into various categories. Assets are sub-classified as current assets and non-current assets;
while liabilities as current liabilities and non-current liabilities. Classifying a balance sheet aids
in the analysis of financial statement data.
When presentation based on liquidity provides accounting information that is reliable and
more relevant to decision-makers then an entity shall present all assets and liabilities in order
of liquidity. For example,
• Assets are classified and presented in decreasing order of liquidity. Cash is the most
liquid. Assets that are least likely to be converted to cash are listed last.
• Liabilities are generally classified and presented based on time of maturity such that
obligations which are currently due are listed first.
It can be observed in Exhibit 4-7 that the total assets of P546,700 in the balance sheet does
not tally with the total debits of P565,700 in the balance sheet columns of the worksheet in
exhibit 4-4. Likewise, the total liabilities and owner’s equity do not equal the total credits in
the same exhibit. The reason for these differences is that accumulated depreciation and
withdrawals are subtracted from their related accounts in the balance sheet but added in
their respective columns in the worksheet. The classified balance sheet of Weddings “R” Us
in report format is:
Weddings “R” Us
Balance Sheet
May 31, 2019
Asset
Current assets
Cash P 22,200
Accounts receivable 17,300
Supplies 15,000
Prepaid rent 4,000
Prepaid insurance 13,200
Total current assets P 71,700
Property and Equipment (net)
Service Vehicles P420,000
Less: accumulated depreciation 4,000 416,000
Office equipment P 60,000
Less: accumulated depreciation 1,000 59,000 475,000
Total assets P546,700
========
Liabilities
Current liabilities
Notes Payable P 210,000
Accounts Payable 53,000
Salaries payable 1,800
Utilities payable 1,400
Interest payable 3,500
Unearned referral revenues 6,000
Total Current Liabilities P275,700
Owner’s Equity
Perez-Manalo, capital, 5/31/2019 271,000
Total Liabilities and Owner’s Equity P546,700
===========
Exhibit 4-7 statement of financial position
The statement of cash flows provides information about the cash receipts and cash payments
of an entity during a period. It is a formal statement that classifies cash receipts (inflows) and
cash payments (outflows) into operating, investing and financing activities. This statement
shows the net increase or decrease in cash during the period and the cash balance at the
end of the period; it also helps project the future net cash flows of the entity. The discussion
below gives an overview of some important concepts involved in the preparation of the cash
flow statement.
Operating activities generally involve providing services, and producing and delivering
goods. Cash flows from operating activities are generally the cash effects of transactions
and other events that enter into the determination of profit or loss. This cash flow can be
presented using either the direct or the indirect method.
Using the direct method, the entity’s net cash provided by (used in) operating activities is
obtained by adding the individual operating cash inflows and then subtracting the individual
operating cash outflows.
The indirect method derives the net cash provided by (used in) operating activities by
adjusting profit for income and expense items not resulting from cash transactions. The
adjustment begins with profit followed by the addition of expenses and charges (e.g.
depreciation) that did not entail cash payments. Then, increases in current assets and
decreases in current liabilities involved in the determination of profit but which did not
actually increase or decrease cash, are subtracted from profit. Finally, decreases in current
assets and increases in current liabilities are added to profit to obtain net cash provided by
(used in) operating activities.
Profit Pxxx
Adjustment for:
Non-cash expenses (e.g. depreciation) xx
Increases in current assets account (xx)
Decreases in current liabilities (xx)
Decreases in current assets xx
Increases in current liabilities xx
Cash flows from operating activities Pxxx
====
For example, increases in accounts receivable from sale of services or goods represented an
increase in profit without the corresponding increase in cash – for it is still a receivable. Since
these revenues are already included in the computation of profit, the increase in accounts
receivable should be deducted from the profit figure. To illustrate further, assume that salaries
payable increased. Increases in salaries payable meant that the entity did not pay the full
amount of salaries expense for the period.
The expense in the income statement, for cash flow purposes, is overstated by the amount of
unpaid salaries. If expense is overstated, then profit is understated by the same amount;
hence, the increase in current liability is added to profit.
Per Philippine Accounting Standards (PAS) no. 7, enterprises are encouraged to report cash
flows from operating activities the direct method but the indirect method is acceptable. Only
the direct method is illustrated here. The following are the major classes of operating cash
flows using the direct method.
Cash Inflows
• Receipts from sale of goods and performance of services
• Receipts from royalties, fees, commissions and other revenues
Cash Outflows
• Payments to suppliers of goods and services
• Payments to employees
• Payments for taxes
• Payments for interest expense
• Payments for other operating expenses
Investing activities include making and collecting loans; acquiring and disposing of
investments in debt or equity securities; and obtaining and selling or property and equipment
and other productive assets.
Cash Inflows
• Receipts from sale of property and equipment
• Receipts from sale of investments in debt or equity securities
• Receipts from collections on notes receivable
Cash Outflows
• Payments to acquire property and equipment
• Payments to acquire debt or equity securities
• Payments to make loans to others generally in the form of notes receivable
Cash Inflows
• Receipts from investment by owners
• Receipts from issuance of notes payable
Cash Outflows
• Payments to owners in the form of withdrawals
• Payments to settle notes payable
Weddings “R” Us
Statement of Cash Flows
For the month ended May 31, 2019
1. The income statement reports all income and expenses during the period. The profit
or loss is the final figure in this statement.
2. The statement of changes in equity considers the profit or loss figure from the income
statement as one of the determining factors that explains the change in owner’s
equity.
3. The statement of financial position reports the ending owner’s equity, taken directly
from the statement of changes in equity.
4. The statement of cash flows reports the net increase or decrease in cash during the
period and ends with the cash balance reported in the balance sheet. This statement
is prepared based on information from the income statement and the balance sheet.
Multiple Choice
1. Which of the following types of information is not found in financial statements?
a. Profits
b. Revenue
c. Selling prices
d. Assets
2. Accounting data flow from the
a. Balance sheet to the income statement
b. Income statement to the statement of owner’s equity
c. Statement of owner’s equity to the balance sheet
d. Both b and c are correct
3. Consider the steps in the accounting cycle. Which part of the accounting cycle
provides information to help a business decide whether to expand its operations?
a. Post-closing trial balance
b. Adjusting entries
c. Closing entries
d. Financial statements
4. Which columns of the accounting work sheet show unadjusted amounts?
a. Trial balance
b. Adjustments
c. Income statement
d. Balance sheet
5. Which columns of the work sheet show profit?
a. Trial balance
b. Adjustments
c. Income statement
d. Both b and c
6. Which situation indicates a loss on the income statement?
a. Total debits equal total credits
b. Total credits exceed total debits
c. Total debits exceed total credits
d. None of the above
7. Which of the following is a cash inflow from financing activities?
a. Receipt from collections on notes receivable.
b. Receipt from interest on notes receivable.
c. Receipt from issuance of notes payable.
d. Receipt from sale of property and equipment.
8. In the adjusted trial balance, the owner’s equity account reflects
a. The beginning of the period balance.
b. The increase to income and expense.
c. The period ending balance.
d. The results of adjusting entries.
9. Which of the following steps comes first in worksheet preparation?
a. Compute each account’s adjusted balance by combining the trial balance
and adjustment figures.
b. Compute profit or loss as the difference between total revenues and total
expenses on the income statement.
c. Enter the account balances in the unadjusted trial balance columns and total
the amounts.
d. Enter the adjusting entries in the adjustment columns and total the amounts.
10. If the income statement debit and credit columns are not equal after adding the
respective columns,
a. an error has been made.
b. The entity either generated a profit or incurred a loss.
c. The entity generated a profit.
d. The entity incurred a loss.
e. The liabilities must exceed the assets.
11. Worksheets are prepared because
a. They aid in the preparation of the financial statements, adjusting entries, and
closing entries.
b. They are necessary for the preparation of the financial statements.
c. They are required by generally accepted accounting principles.
d. They constitute a permanent record of all adjusting entries made for the
period.
12. Which of the following is an example of an investing activity?
a. Obtaining a bank loan
b. Paying taxes to the government
c. Producing goods and services
d. Purchasing a building
13. Which of the following is an example of a financing activity?
a. Acquiring land
b. Employing workers
c. Paying off a loan
d. Selling equipment
14. The statement of changes in equity would not show
a. revenues and expenses
b. the owner’s ending capital balance
c. the owner’s initial capital balance
d. the owner’s withdrawals for the period
EVALUATION : QUIZ
CHAPTER 5 Completing the Accounting Cycle
Learning Objectives:
The adjustment process is a key element of accrual basis accounting. The worksheet helps
in the identification of the accounts that need adjustments. The adjusting entries are directly
entered in the worksheet. Most accountants prepare the financial statements immediately
after completing the worksheet. The adjustments are journalized and posted as the closing
entries are made. This step in the accounting cycle brings the ledger into agreement with the
data reported in the financial statements.
Income, expense and withdrawal accounts are temporary accounts that accumulate
information related to a specific accounting period. These temporary accounts facilitate
income statement preparation. At the end of each year, the balances of these temporary
accounts are transferred to the capital account. Thus, the balance of the owner’s capital
account represents the cumulative net result of income, expense, and withdrawal
transactions. This phase of the cycle is called the closing procedure.
A temporary account is said to be closed when an entry is made such that its balance
becomes zero. Closing simply transfer the balance of one account to another account. In
this case, the balances of the temporary accounts are transferred to the capital account. A
summary account-Income Summary is used to close the income and expense accounts. The
steps in closing the accounts of an entity will be illustrated using the Weddings “R” Us case.
Income accounts have credit balances before the closing entries are posted. For this
reason, an entity debiting each revenue account in the amount of its balance is
needed to close the account. The credit is made to the income summary account.
The entry to close the income accounts for the Weddings “R” Us is as follows:
The dual effect of the entry is to make the balances of the income accounts equal to
zero, and to transfer the balances in total to the credit side of the income summary
account. Note that the data for closing the income accounts can be found in the
credit side of the income statement columns of the worksheet in exhibit 4-4.
Expense accounts have debit balances before the closing entries are posted. For this
reason, a compound entry is needed crediting each expense account for its balance
and debiting the income summary for the total. These data can be found in the debit
side of the income statement columns of the worksheet.
2019 Debit credit
May 31 Income Summary 330 36,700
Salaries Expense 510 15,600
Supplies Expense 520 3,000
Rent expense 530 4,000
Insurance expense 540 1,200
Utilities expense 550 4,400
Depreciation expense-SV 560 4,000
Depreciation expense – OE 570 1,000
Interest expense 590 3,500
The effect of posting the closing entry is to reduce the expense account balances to
zero and to transfer the total of the account balances to the debit side of the income
summary account.
After posting the closing entries involving the income and expense accounts, the
balance of the income summary account will be equal to the profit or loss for the
period. A profit is indicated by a credit balance and a loss by a debit balance. The
income summary account, regardless of the nature of its balance, must be closed to
the capital account. For the Weddings “R” Us, the entry is as follows:
2019 Debit Credit
May 31 Income summary 330 35,000
Perez-Manalo, Capital 310 35,000
The effect of posting this closing entry is to close the income summary account
balance and to transfer the balance to Perez-Manalo’s capital account for the profit.
The withdrawals account shows the amount by which capital is reduced during the
period by withdrawals of cash or other assets of the business by the owner for personal
use. For this reason, the debit balance of the withdrawal account must be closed to
the capital account as follows:
2019 Debit Credit
May 31 Perez-Manalo, Capital 310 14,000
Perez – Manalo, withdrawals 320 14,000
The effect of posting this closing entry is to close the withdrawal account and to
transfer the balance to the capital account.
It is possible to commit an error in posting the adjustments and closing entries to the ledger
accounts; thus, it is necessary to test the equality of the accounts by preparing a new trial
balance. This final trial balance is called a post-closing trial balance.
• The post-closing trial balance verifies that all the debits equal the credits in the trial
balance.
• The trial balance contains only balance sheet items such as assets, liabilities, and
ending capital because all income and expense accounts, as well as the withdrawals
account, have zero balances.
Notice that only the balance sheet accounts have balances because at this point, all the
income statement accounts have been closed.
Weddings “R” Us
Post –Closing Trial Balance
May 31, 2019
Debit Credit
Cash P 22,200
Accounts receivable 17,300
Supplies 15,000
Prepaid rent 4,000
Prepaid insurance 13,200
Service vehicle 420,000
Accumulated Depreciation –service vehicle P 4,000
Office equipment 60,000
Accumulated depreciation –office equipment 1,000
Notes payable 210,000
Accounts payable 53,000
Salaries payable 1,800
Utilities payable 1,400
Interest payable 3,500
Unearned referral revenues 6,000
Perez – Manalo, Capital 271,000
P 551,700 P 551,700
======== ========
REVERSING ENTRIES (step 10)
Preparing the post-closing trial balance may not be the last step in the accounting cycle.
Some entities elect to reverse certain end-of-period adjustments on the first day of the new
period. A reversing entry is a journal entry which is the exact opposite of a related adjusting
entry made at the end of the period. It is basically a bookkeeping technique made to simply
the recording of regular transactions in the next accounting period.
It should be emphasized that reversing entries are optional. Also, the act of reversing a
previously recorded adjusting entry should not lead us to the conclusion that the entries
reversed are unnecessary or inaccurate.
Even when an entity follows the policy of making reversing entries, not all adjusting entries
should be reversed. Generally, a reversing entry should be made for any adjusting entry that
increased an asset or a liability account. Therefore, all accruals are reversed but only
deferrals initially recorded in income statement –income or expense – accounts are reversed
Using the summary of adjusting entries in chapter 4, the veracity of the general rule stated in
the previous paragraph can be proven. For example, in the case of a prepaid expense
initially recorded in an expense account, the adjusting entry debited an asset – prepaid
expense. An asset increased; hence, applying the general rule, this adjustment can be
reversed.
After analyzing the rest of the adjusting entries, the adjustments that can be reversed are as
follows: prepaid expenses (expense method), unearned revenues (income method),
accrued expenses and accrued revenues.
Illustration. To show how reversing entries can be helpful, consider the adjusting entry made
in the records of Weddings “R” Us to accrue salaries expense:
2019
May 31 Salaries expense 1,800
Salaries payable 1,800
When the employees are paid on the next regular payday, the entry would be:
2019
June 10 Salaries payable 1,800
Salaries expense 5,400
Cash 7,200
Note that when the payment is made, without a prior reversing entry, the accountant must
look into the records to find out how much of the P7,200 applies to the current accounting
period and how much was accrued at the beginning of the period.
This step may appear easy in this simple case, but think of the problems that may arise it the
company has many employees, especially if some of them are paid on different time
schedules such as weekly or monthly. A reversing entry is an accounting procedure that helps
to solve this difficult problem. As noted above, a reversing entry is exactly what its name
implies. It is a reversal of the adjusting entry made. For example, observe the following
sequence of transactions and their effects on the ledger account- salaries expense:
1. Adjusting Entry
2019
May 31 Salaries expense 1,800
Salaries payable 1,800
2. Closing Entry
2019
May 31 Income summary 15,600
Salaries expense 15,600
3. Reversing Entry
2019
June 1 Salaries payable 1,800
Salaries expense 1,800
4. Payment Entry
2019
June 10 Salaries expense 7,200
Cash 7,200
EVALUATION:
1. Homework
2. quizzes
Learning Objectives:
Service entities perform services for a fee. In ascertaining profit, a basic income statement is
all that is needed. In figure 6-1, profit is measured as the difference between revenues from
services and expenses. In contrast, merchandising entities earn profit by buying and selling
goods. These entities use the same basic accounting methods as service entities, but the
process of buying and selling merchandise requires some additional accounts and concepts.
This process results in a more complex income statement. To provide a better measure of
performance, the income statement of a merchandising business is presented with additional
items:
Service Merchandising
Income Statement Income Statement
Figure 6-1 Components of Income Statements for Service and Merchandising Entities
In a merchandising business, net sales arise from sale of goods while cost of sales or cost of
goods sold represents the cost of inventory the entity has sold to customers. The difference
between net sales and cost of sales is called gross profit. Then, other operating income is
added and operating expenses (like distribution costs, administrative expenses and other
operating expenses) are deducted from gross profit to arrive at operating profit. Investment
revenues, other gains and losses, and finance costs (e.g. interest expense) are considered to
arrive at profit before tax then income tax expense is deducted to have profit from continuing
operations. Finally, profit from discontinued operations (net of tax) is taken to account to get
profit for the period.
Gloria Detoya traders
Income Statement
For the year ended December 31, 2019
The merchandising entity purchases inventory, sells the inventory and uses the cash to
purchase more inventory –and the cycle continues. For cash sales, the cycle is from cash to
inventory and back to cash. For sales on account, the cycle is from cash to inventory to
accounts receivable and back to cash. In any industry, the manager strives to shorten the
cycle. The faster the sale of inventory and the collection of cash, the higher the profits
SOURCE DOCUMENTS
Merchandising businesses use various business forms and documents to help identify the
transactions that should be recorded in the books. These source documents contain vital
information about the nature and amount of the transactions.
1. Sales invoice is prepared by the seller of goods and sent to the buyer. This document
contains the name and address of the buyer, the date of sale and information-
quantity, description and price – about the goods sold. It also specifies the amount
of sales, and the transportation and payment terms.
2. The bill of lading is a document issued by the carrier-a trucking, shipping or airline –
that specifies contractual conditions and terms of delivery such as freight terms, time,
place, and the person named to receive the goods.
3. The statement of account is a formal notice to the debtor detailing the accounts
already due.
4. The official receipt evidences the receipt of cash by the seller or the authorized
representative. It notes the invoices paid and other details of payment.
5. Deposits slips are printed forms with depositor’s name, account number and space
for details of the deposit. A validated deposit slip indicates that cash and checks with
the supplied details were actually deposited or credited to the account holder.
6. A check is a written order to a bank by a depositor to pay the amount specified in the
check from his checking account to the person named in the check. The entity issuing
the check is the payor while the receiver is the payee.
7. The purchase requisition is a written request to the purchaser of an entity from an
employee or user department of the same entity that goods be purchased.
8. The purchase order is an authorization made by the buyer to the seller to deliver the
merchandise as detailed in the form.
9. Receiving report is a document containing information about goods received from a
vendor. It formally records the quantities and description of the goods delivered.
10. A credit memorandum is a form used by the seller to notify the buyer that his account
is being decreased due to errors or other factors requiring adjustments.
Whenever a purchase or sale of merchandise occurs, the buyer and the seller should agree
on the price of the merchandise, the payment terms and the party to shoulder the
transportation costs. Owners of small merchandising firms may settle these terms informally
by phone or by discussion with the vendor’s representative. Most large businesses, however,
follow certain procedures when purchasing merchandise.
All of the above forms – purchase requisition, purchase order, invoice and receiving report –
are source documents. When the goods are received or when title has passed, the entity
should record purchases and a liability (or a cash disbursement). Generally, the seller
recognizes the sales transaction in the records when the goods have been shipped.
TERMS OF TRANSACTIONS
Merchandise may be purchased and sold either on credit terms or for cash on delivery. When
goods are sold on account, a period of time called the credit period is allowed for payment.
The length of the credit period varies across industries and may even vary within an entity,
depending on the product.
When goods are sold on credit, both parties should have an understanding as to the amount
and time of payment. These terms are usually printed on the sales invoice and constitute part
of the sales agreement. If the credit period is 30 days, then payment is expected within 30
days from the invoice date. The credit period is usually described as the net credit period or
net terms. The credit period of 30 days is noted as “n/30”. If the invoice is due ten days after
the end of the month, it may be marked “n/10 eom”.
Cash Discounts
Some businesses gives discounts for prompt payment called cash discounts. If a trade
discount is also offered, cash discount is computed on the net amount after the trade
discount. This practice improves the seller’s cash position by reducing the amount of money
in accounts receivable. Cash discount is designated by such notation as “2/10” which means
the buyer may avail of a two percent discount if the invoice is paid within ten days from the
invoice date. The period covered by the discount, in this case –ten days, is called the
discount period.
Cash discounts are called purchase discounts from the buyer’s viewpoint and sales discounts
from the seller’s point of view.
It is usually worthwhile for the buyer to take a discount if offered although it may be necessary
to borrow the money to make the payment.
Illustration. Assume that an invoice for P150,000 with terms 2/10,n/30, is to be paid within the
discount period with money borrowed for the remaining 20 days of the credit period. If an
annual interest rate of 18 percent is assumed, the net savings to the buyer is P1,530 which is
determined as follows:
Cash discount of 2% on P150,000 P3,000
Interest for 20 days at annual rate of 18% on the amount
Due within the discount period. P147,000 x 18% x20/360 1,470
Savings effected by borrowing P1,530
======
Trade Discounts
Suppliers furnish smaller wholesalers or retailers with price lists and catalogs showing suggested
retail prices for their products. These firms, however, also include a schedule of trade
discounts from the listed prices to enable the customer to determine the invoice price to be
paid. Trade discounts encourage the buyers to purchase products because of markdowns
from the list price. Trade discounts should not be confused with cash discounts. This type of
discount enables the suppliers to vary prices periodically without the inconvenience of
revising price lists and catalogs.
There is no trade discount account and there is no special accounting entry for this discount.
Instead, all accounting entries are based on the invoice price which is obtained by
subtracting the trade discount from the list price.
Illustration. Pinnacle Technologies quoted a list price of P2,500 for each 64 gigabyte flash
drive, less a trade discount of 20%. If Video Fantastic ordered seven units, the invoice price
would be as follows:
List price (P2,500 x 7) P17,500
Less: 20% trade discount 3,500
Balance P14,000
Less: 10% trade discount 1,400
Invoice price P12,600
=======
In the first example, both the buyer and the seller would record only the P14,000 invoice price
while in the second example, the invoice price will be P12,600.
Transportation Costs
When merchandise is shipped by a common carrier – a trucking entity or an airline –the carrier
prepares a freight bill in accordance with the instructions of the party making the shipping
arrangements. The freight bill designates which party shoulders the costs, and whether the
shipment is freight prepaid or freight collect.
Freight bills usually show whether the shipping terms are FOB shipping point or FOB destination.
FOB is an abbreviation for “free on board”. When the freight terms are FOB shipping point,
the buyer shoulders the shipping costs; ownership over the goods passes from seller to the
buyer when the inventory leaves the seller’s place of business- the shipping point. The buyer
already owns the goods while still in transit and therefore, shoulders the transportation costs.
If the terms are FOB destination, the seller bears the shipping costs. Title passes only when the
goods are received by the buyer at the point of destination; while in transit, the seller is still
the owner of the goods so the seller shoulders the transportation costs.
In freight prepaid, the seller pays the transportation costs before shipping the goods sold;
while in freight collect, the freight entity collects from the buyer. Payment by either party will
not dictate who should ultimately shoulder the costs.
Normally, the party bearing the freight cost pays the carrier. Thus, goods are typically shipped
freight collect when the terms are FOB shipping point; and freight prepaid when the terms
are FOB destination.
Sometimes, as a matter of convenience, the firm not bearing the freight costs pays the carrier.
When this situation occurs, the seller and buyer simply adjust the amount of the payment for
the merchandise. Figure 6-3 shows which party- the buyer or the seller shoulders the
transportation costs and pays the shipper for various freight terms.
Freight Terms who shoulders the transportation who pays the
Costs? shipper?
FOB destination, freight prepaid seller seller
FOB shipping point, freight collect buyer buyer
FOB destination, freight collect seller buyer
FOB shipping point, freight prepaid buyer seller
The shipping costs borne by the buyer using the periodic inventory system are debited to
transportation in account. In accounting, the cost of an asset – the merchandise inventory –
includes all costs (e.g. shipping costs) incurred to bring the asset to its intended use. In the
cost of sales section of the income statement, the balance in this account is added to
purchases in computing for the net cost of purchases for the period.
Shipping costs borne by the seller are debited to transportation out account. This account
which is also called delivery expense, is an operating expense in the income statement.
INVENTORY SYSTEMS
Merchandise inventory is the key factor in determining cost of sales. Because merchandise
inventory represents goods available for sale, there must be a method of determining both
the quantity and the cost of these goods. There are two systems available to merchandising
entities to record events related to merchandise inventory: the perpetual inventory system
and the periodic inventory system.
The perpetual inventory system is an alternative to the periodic inventory system. Under the
perpetual inventory system, the inventory account is continuously updated. Perpetually
updating the inventory account requires that at the time of purchase, merchandise
acquisitions be recorded as debits to the inventory account. At the time of sale, the cost of
sales is determined and recorded by a debit to the cost of sales account and a credit to the
inventory account. With a perpetual inventory system, both the inventory and cost of sales
accounts receive entries throughout the accounting period.
Many merchandising entities are now using the perpetual inventory system with point of sale
equipment. Computers have decreased in prices. These powerful machines have
dramatically reduced the time required to manage inventory. Supermarket and department
stores use point-of-sale scanners built into checkout counters to collect transactional data for
the cash register and to update their perpetual inventory system. In the absence of point of
sales scanners, the perpetual inventory system is more advisable for firms that sell low-volume,
high-priced goods such as motor vehicles, jewelry and furniture.
When an entity uses the perpetual inventory system, the ending inventory should reconcile
with the actual physical count at the end of the period assuming that no theft, spoilage, or
error has occurred. Even if there is a little chance for or suspicion of inventory discrepancy,
most entities make a physical count. At that time, the account is adjusted for any
inaccuracies discovered. The count provides an independent check on the amount of
inventory that should be reported at the end of the period.
The periodic inventory system is primarily used by businesses that sell relatively inexpensive
goods and that are not yet using computerized scanning systems to analyze goods sold. A
characteristic of the periodic inventory system is that no entities are made to the inventory
account as the merchandise is bought and sold. When goods are purchased, a separate
set of accounts –purchases, purchases discounts, purchases returns and allowances, and
transportation in –is used to accumulate information on the net cost of the purchases. Only
at the end of the period, when the inventory is counted, will entries be made to the inventory
account to establish it s proper balance. The periodic inventory system will be used in the
succeeding discussions. To illustrate the major parts of the merchandising income statement,
selected transactions made by G. Detoya Traders will be used unless otherwise stated.
Net sales
Net sales is the first part of the merchandising income statement as presented below:
Gloria Detoya Traders
Partial Income Statement
For the year ended December 31, 2019
Net sales
Gross sales P 2,463,500
Less: Sales returns and allowances P27,500
Sales discounts 42,750 70,250
Net sales P 2,393,250
=========
Exhibit 6-2 partial Income Statement –net sales
Gross Sales
Under accrual accounting, revenues from the sale of merchandise are considered to be
earned in the accounting period in which the tittle of goods passes-usually at the point of
delivery –from the seller to the buyer. Gross sales consist of total sales for cash and on credit
during an accounting period. Although cash for the sale is uncollected, the revenue is
recognized as earned at the time of the sale. For this reason, there is likely to be a difference
between net sales and cash collected from those sales in a given period.
As an income account, the sales account is credited whenever sales on account or cash
sales are made. Only sales of merchandise held for resale are recorded in the sales account.
If a merchandising firm sold one of its delivery trucks, the credit would be made to the delivery
equipment account, not to sales account.
The journal entry to record the sale of merchandise for cash is as follows:
Sept. 16 Cash 25,000
Sales 25,000
To record sale of merchandise for cash
Sales Discounts
Assume that G. Detoya Traders sold merchandise on Sept. 20 for P3,000; terms 2/10, n/60. At
the time of sale, the entry is:
Sept. 20 Accounts Receivable 3,000
Sales 3,000
To record sales on credit; terms 2/10,n/60
The customer may take advantage of the sales discount any time on or before Sept. 30,
which is 10 days after the date of the invoice. If the client paid on Sept. 30, the entry is:
Sept. 30 Cash 2,940
Sales discounts 60
Accounts Receivable 3,000
To record collection on the sept. 20 sale, discounts
taken.
At the end of the accounting period, the sales discounts account has accumulated all the
sales discounts for the period. The account is considered a contra-income account and
deducted from gross sales in the income statement (see exhibit 6-2)
Buyers may be dissatisfied with the merchandise received either because the goods are
damaged or defective, of inferior quality or not in accordance with their specifications. In
such a cases, the buyer may return the goods to the seller for credit if the sale was made on
account or for cash refund if the sale was for cash.
Alternatively, the seller may just grant an allowance or deduction from the selling price. A
high sales returns and allowances figure is not commendable because it may signal poor
quality of goods and thus may result to dissatisfied customers.
Each return or allowance is recorded as a debit to an account called sales returns and
allowances. An example of such transaction follows:
Sept. 17 Sales returns and allowances 760
Accounts receivable or cash 760
To record return or allowance on
unsatisfactory merchandise
The seller usually issues the customer a credit memorandum (i.e. accounts receivable or cash
is credited), which is a formal acknowledgment that the seller has reduced the amount owed
by the customer. Sales returns and allowances is a contra-income account and is
accordingly deducted from gross sales in the income statement (see exhibit 6-2).
Transportation Out
When the freight term FOB destination, the seller shoulders the transportation costs; when the
term is FOB shipping point, the buyer bears the shipping costs.
Case 1. Assume that G. Detoya Traders sold merchandise totaling P17,000 FOB destination,
freight prepaid; terms 2/10, n/30. The transportation costs amounted to P1,900. The entry to
record this transaction would be:
Nov. 25 Accounts Receivable 17,000
Transportation out 1,900
Sales 17,000
Cash 1,900
Sales on account; terms 2/10,n/30; FOB
destination, freight prepaid P1,900
If this invoice is collected on December 5, the sales discount will be P340 (P17,000 x 2%).
Transportation out is an operating expense or selling expenses.
Dec. 5 Cash 16,660
Sales discounts 340
Accounts receivable 17,000
Case 2. Assume that G. Detoya Traders sold merchandise totaling P17,000 FOB shipping
point, freight collect; terms 2/10, n/30. The transportation costs amounted to P1,900. The
entry to record this transaction would be:
Nov. 25 Accounts receivable 17,000
Sales 17,000
To record merchandise on account; terms
2/10, n/30; FOB shipping point, freight collect
There is no debit to transportation out account since the shipping term provided that the
buyer should shoulder the transportation costs. If this invoice is collected on December 5,
the sales discount will be P340 (17,000 x 2%). The entry would be:
Dec. 5 Cash 16,660
Sales discounts 340
Accounts receivable 17,000
Case 3. Now, assume that G. Detoya Traders sold merchandise totaliing P17,000 FOB
destination, freight collect; terms 2/10, n/30. The transportation costs amounted to P1,900.
The entry to record this transaction would be:
Nov. 25 Accounts receivable 15,100
Transportation out 1,900
Sales 17,000
Sales on account; terms 2/10, n/30, FOB
destination, freight collect, P1,900.
Accounts receivable is decreased by the transportation charges paid by the buyer for the
benefit of the seller. If this invoice is collected on Dec. 5, the sales discount will be P340 (17,000
x 2%) since the discount applies to total sales.
Dec. 5 Cash 14,760
Sales discounts 340
Accounts receivable 15,100
Case 4. Assume further that G. Detoya Traders sold merchandise totaling P17,000 FOB
shipping point, freight prepaid; 2/10, n/30. The transportation costs amounted to P1,900. The
entry to record this transaction would be:
Nov. 25 Accounts receivable 18,900
Sales 17,000
Cash 1,900
Sales on account; terms 2/10, n/30; FOB
shipping point, freight prepaid, P1,900
If this invoice is collected on December 5, the sales discount will be P340 (P17,000 x 2%). The
discount only applies to total sales.
Dec. 5 Cash 18,560
Sales discounts 340
Accounts receivable 18,900
COST OF SALES
Cost of sales or cost of goods sold is the largest single expense of the merchandising business.
It is the cost of inventory that the entity has sold to customers. Every merchandising business
has goods available for sale to customers. The goods available for sale during the year is the
sum of two factors – merchandise inventory at the beginning of the year and net cost of
purchases during the period.
If an entity is able to sell all the goods available for sale during a given accounting period,
the cost of sales would then equal goods that had been available for sale. In most cases,
however, the business will have goods still unsold at the end of the year. To find the actual
cost of sales, the merchandise inventory at the end of the period is subtracted from the goods
available for sale.
Exhibit 6-3 showed goods costing P1,796,600 as available for sale-G. Detoya started with
P528,000 in beginning merchandise inventory and net cost of purchases (or cost of goods
purchased) of P1,268,600 during the year. At the end of the year, P483,000 of goods were
left unsold; this amount should appear as the merchandise inventory in the balance sheet.
When this ending merchandise inventory is subtracted from goods available for sale, the
resulting cost of sales is P1,313,600.
Cost of sales
Merchandise inventory, 1/1/2019 P 528,000
Purchases P 1,264,000
Less: Purchases Returns and Allowances P 56,400
Purchases discounts 21,360 77,760
Net purchases P 1,186,240
Transportation In 82,360
Net cost of purchases 1,268,600
Goods available for sale P1,796,600
Less: Merchandise inventory, 12/31/2019 483,000
Cost of sales P1,313,600
=========
Exhibit 6-3 Partial Income Statement –cost of sales
Merchandise Inventory
The inventory of a merchandising entity consists of goods purchased for resale. For a grocery
store, inventory would be made up of meats, vegetables, canned goods, and other items.
For a lumber and hardware, it would be plywood, nails, paints, iron sheets, cement, tools and
other items. Merchandising entities purchase their inventories from manufacturers,
wholesalers and other suppliers.
The merchandise inventory at the beginning of the accounting period is called the beginning
inventory. Conversely, the merchandise inventory at the end of the accounting period is
called the ending inventory. As presented in exhibit 6-3, beginning and ending inventory are
used in calculating cost of sales in the income statement. The ending inventory shown in the
income statement will be the merchandise inventory to be reported in the balance sheet.
Effectively, the ending inventory of the current period will be the beginning inventory of the
next period.
Purchases
When the periodic inventory method is used, all purchases of merchandise are debited to
the purchases account as shown below:
Nov. 12 Purchases 15,000
Accounts payable 15,000
To record purchases of merchandise; terms
2/10, n/30
The purchases account, a temporary account, is used only for merchandise purchased for
resale. Its sole purpose is to accumulate the total cost of merchandise purchased during an
accounting period. Purchases of other assets such as equipment should be recorded in the
appropriate assets accounts. Recording merchandise purchases at invoice price is known
as the gross price method of recording purchases.
Sales returns and allowances in the seller’s books are recorded as purchases returns and
allowances in the books of the buyer. This should be recorded as follows:
Nov. 14 Accounts payable 2,000
Purchases returns and allowances 2,000
Return of damaged merchandise purchased
on November 12.
Purchases returns and allowances is a contra account and is accordingly deducted from
purchases in the income statement (see exhibit 6-3). It is important that a separate account
be used to record purchases returns and allowances because management needs the
information for decision making.
It may be very costly to return merchandise. There are costs that cannot be recovered such
as ordering costs, accounting costs, transportation costs, and interest on the money invested
in the goods. There may also be lost sales resulting from poor ordering or unsaleable goods.
Frequent returns may call for new purchasing procedures or suppliers.
Purchases Discounts
Merchandise purchases are usually made on credit and commonly involve purchases
discounts for early payment. In relation to the Nov. 12 and 14 transactions, the payment is
recorded as follows:
Nov. 14 Accounts payable 13,000
Purchases discount (P13,000 x 2%) 260
Cash 12,740
Like purchases returns and allowances, purchases discounts is a contra account that is
deducted from purchases on the income statement. If the entity makes a partial payment
on an invoice, most creditors will allow the entity to take the discount applicable to the partial
payment. The discount does not apply to transportation or other charges that might appear
on the invoice.
Transportation In
Case 1. Assume that G. Detoya Traders made purchases totaling P17,000 FOB destination,
freight prepaid; terms 2/10, n/30. Transportation costs amounted to P1,900. The entry would
be:
Nov. 25 Purchases 17,000
Accounts payable 17,000
Purchased merchandise on account; terms 2/10,
n/30; FOB destination freight prepaid.
There is no debit to transportation in account since the shipping term provided that the seller
should shoulder the transportation costs. In addition, the seller prepaid the freight. If this
invoice is paid on December 5, the purchases discount will be P340 (P17,000 x 2%). The entry
would be:
Dec. 5 Accounts payable 17,000
Purchases discounts 340
Cash 16,660
Case 2. Assume that G. Detoya made purchases totaling P17,000 FOB shipping point, freight
collect; terms 2/10, n/30. The transportation costs amounted to P1,900. The entry to record
this transaction would be:
Nov. 25 Purchases 17,000
Transportation 1,900
Accounts payable 17,000
Cash 1,900
Purchases on account; terms 2/10, n/30; FOB
shipping point, freight collect, P1,900.
If this invoice is paid on Dec. 5, the purchases discount will be P340 (P17,000 x 2%).
Transportation in will form part of the net cost of purchases.
Dec. 5 Accounts payable 17,000
Purchases discounts 340
Cash 16,660
Case 3. Now, assume that G. Detoya Traders made purchases totaling P17,000 FOB
destination, freight collect; terms 2/10, n/30. The transportation costs amounted to P1,900.
The entry to record this transaction would be:
Nov. 25 Purchases 17,000
Accounts payable 15,100
Cash 1,900
Purchases on account; terms 2/10, n/30; FOB
destination, freight collect, P1,900.
Accounts payable is decreased by the transportation charges paid by the buyer for the
benefit of the seller. If this invoice is paid on Dec. 5, the purchases discount will be P340
(P17,000 x 2%) because the discount applies to total purchases.
Dec. 5 Accounts payable 15,100
Purchases discounts 340
Cash 14,760
Case 4. Assume further that G. Detoya Traders made purchases totaling P17,000 FOB
shipping point, freight prepaid; terms 2/10, n/30. The transportation costs amounted to
P1,900. The entry to record this transaction would be:
Nov. 25 Purchases 17,000
Transportation in 1,900
Accounts payable 18,900
Purchased merchandise on account; terms 2/10,
n/30; freight prepaid, P1,900.
If this invoice is paid on Dec. 5, the purchases discount will be P340 (P17,000 x 2%). The buyer
is not entitled to discounts on the transportation costs. Discounts apply only to total
purchases.
Dec. 5 Accounts payable 18,900
Purchases discount 340
Cash 18,560
It will be useful to contrast these “transportation In entries to the “transportation Out” entries
discussed earlier.
Input tax increased the amount to be paid but has no effect on the cost of the purchases.
Output tax also increased the amount collected but not necessarily, the sales figure. The
value of goods or properties sold and subsequently returned or for which allowances were
granted by a VAT-registered person may be deducted from the gross sales or receipts for the
quarter in which the refund is made or a credit memorandum is issued. Sales discounts
granted or indicated in the invoice at the time of sale may be excluded from the gross sales
within the same quarter it was given.
Illustration. Assume that the wholesaler purchased the feeds from Dela Cruz on account and
that a 2% sales discount is available if the account is settled within 10 days from invoice date.
Dela Cruz was able to collect the account on May 30. The related entry follows:
May 30 Cash 1,097,600
Output tax 2,400
Sales discount 20,000
Accounts receivable 1,120,000
Remedios Palaganas, because of the sales discounts granted, will pay value-added tax due
of 33,600 only.
OPERATING EXPENSES
Operating expenses make up the third major part of the income statement for a
merchandising entity. These are expenses, other than the cost of sales, which are incurred to
generate profit from the entity’s major line of business- merchandising. It is customary to
group operating expenses into useful categories. Distribution costs, administrative expenses
and other operating expenses are the categories.
Distribution costs or selling expenses are those expenses related directly to the entity’s efforts
to generate sales. These include sales salaries and commissions, and the related employer
payroll expenses; advertising and store displays; traveling expenses; store supplies used;
depreciation of store property and equipment; and transportation out.
Administrative expenses are those expenses related to the general administration of the
business. These include officers and office salaries, and the related employer payroll
expenses; office supplies used; depreciation of office property and equipment; business
taxes; professional services; uncollectible accounts expense and other general office
expenses.
Other operating expenses are those expenses that are not related to the central operations
of the business. These are expenses and losses from peripheral or incidental transactions of
the enterprise; for example, loss on sale of investments or loss on sale of property and
equipment.
Multiple Choice
1. A supplier offers the following discounts: Trade discounts of 10% at list price and
another cash discount of 5% if paid in full before the due date. How much is to be
paid if a customer pays before due date at a list price of P16,000?
a. P13,680
b. P15,520
c. P14,000
d. P16,000
2. A trade discount is:
a. shown in the sales journal
b. shown in the purchase journal
c. shown in the general journal
d. not shown anywhere
3. Which account does a merchandiser, but not a service entity, use?
a. Sales
b. Inventory
c. Cost of goods sold
d. All of the above
4. The two main inventory accounting systems are the following
a. purchase and sale
b. returns and allowances
c. cash and accrual
d. perpetual and periodic
5. Which of the following activities is not a component of the operating cycle?
a. Collection of cash from merchandise sales.
b. Ordering of merchandise.
c. Purchase of merchandise.
d. Sale of merchandise.
QUIZ
Learning Objectives:
1. Recognize the need for a physical count and analyze the effects of omitting the
procedure.
2. Determine the entries for merchandise inventory using either the adjusting entry
method or the closing entry method.
3. Prepare the adjusting entries for a merchandising entity.
4. Recognize the need for a worksheet and summarize how the new accounts related
to merchandising transactions are handled in the worksheet.
5. Prepare accurately and in good form a ten column worksheet.
6. Understand and appreciate the usefulness of financial statements.
7. Develop skills in the preparation of financial statements.
8. Compare income statements prepared under the nature of expense and function of
expense methods.
9. Explain why temporary accounts are closed each period.
10. Recognize the need for a post-closing trial balance and reversing entries in particular
instances.
11. Prepare closing entries, post –closing trial balance and reversing entries.
12. Explain how the worksheet under a perpetual inventory system differs from that
prepared under a periodic inventory system.
Notice that in both methods, merchandise inventory is credited for the beginning balance
and debited for the ending balance and that the opposite entries are made to income
summary.
The worksheet of a merchandising business is the same as that of a service business except
that it has to deal with the new accounts related to merchandising transactions. These
accounts include sales, sales returns and allowances, sales discounts, purchases, purchases
returns and allowances, purchase discounts, transportation in, merchandise inventory and
transportation out. The worksheet for G. Detoya Traders using the closing entry method is
shown in exhibit 7-1. Each pair of columns in the worksheet, and the adjusting and closing
entries are discussed as follows.
Trial Balance Columns. The first step in the preparation of the worksheet is to enter the
balances from the ledger accounts into the trial balance columns. The merchandise
inventory account balance of P528,000 is the cost of beginning inventory.
Adjustment Columns. Under the closing entry method of handling merchandise inventory,
the adjusting entries for G. Detoya Traders are entered in the adjustments columns in the
same way that they were for service entities. These involve insurance expired during the
period (adjustment a); store and office supplies used (adjs. b & c); depreciation of building
and office equipment (adjs. d & e); accrual of interest expense (adj. f); no adjustment entry
is made for merchandise inventory because the closing entry method was used. After the
adjusting entries are entered in the worksheet, the trial balance columns and adjustment
columns are totaled to prove the equality of the debits and credits.
Omission of Adjusted Trial Balance Columns. These two columns are used when there are
many adjusting entries to be considered. When only a few adjusting entries are required, as
in this case, these columns are not necessary and may be omitted.
Income Statement and Balance Sheet Columns. After the trial balance columns have been
totaled, the adjustments entered, and the equality of the columns proved, the balances are
extended to the statement columns. Each account balance is entered in the proper column
of the income statement or balance sheet.
The extension of the beginning and ending inventory balances requires some new
procedures. First, the beginning inventory balance of P528,000 is extended to the debit
column of the income statement as illustrated in exhibit 7-1. This procedure has the effect of
adding beginning inventory to net cost of purchases; observe that the purchases account is
also in the debit column of the income statement.
Second, the ending inventory balance of P483,000 which is not in the trial balance is entered
in the credit column of the income statement. This procedure has the effect of subtracting
the ending inventory from goods available for sale. Note that two inventory amounts
appeared in the income statement columns. This because both the beginning inventory and
the ending inventory are needed in the computation of cost of sales.
Finally, the ending inventory is also entered in the debit column of the balance sheet. After
all the items have been extended to the proper statement columns, the four columns are
totaled. The profit or loss is determined as the difference between the debit and credit
columns of the income statement. In this case, G. Detoya Traders earned a profit of P455,210,
which is extended to the credit column of the balance sheet. The four columns are then
added to prove the equality of the debits and credits.
Income statement
The discussion on the major parts of the income statement for a merchandising entity has
been made in the previous chapter. The statement may be prepared by referring to the
income statement columns of the worksheet. Per revised PAS no. 1, an enterprise should
present an analysis of expenses using a classification based on either the nature of expenses
or their function within the entity, whichever provides information that is reliable and more
relevant. Entities are encouraged to present the analysis of expenses on the face of the
income statement.
Expenses are aggregated or combined in the income statement according to their nature
and are not reallocated among various functions within the entity. This method is simple to
apply in many smaller enterprises because no allocation of operating expenses between
functional classifications is necessary. Examples include raw materials and consumables
used, employee benefits expense, depreciation and amortization expense, transportation
costs, advertising costs and other operating expenses.
This method, also referred to as the “cost of sales” method, classifies expenses according to
their function as part of cost of sales, distribution/selling, administrative and other operating
activities. This presentation often provides information that is more relevant to users than
nature of expense method but the allocation of costs to functions can be arbitrary and
involves considerable judgment. This method provides multiple classifications and
intermediate differences to highlight significant relationships.
In a merchandising business, net sales arise from the sale of goods while cost of sales or cost
of goods sold represents the cost of inventory the entity has sold to customers. The difference
between net sales and cost of sales is called gross profit.
Then, other operating income is added and operating expenses (like distribution costs,
administrative expenses and other operating expenses) are deducted fro gross profit to arrive
at operating profit.
Investment revenue, other gains and losses, and finance costs (e.g. interest expense) are
considered to arrive at profit before tax then income tax expense is deducted to arrive at
profit from continuing operations. Finally, profit from discontinued operations (net of tax) is
taken to account to get profit for the period.
Exhibit 7-2 shows the income statement for G. Detoya Traders using the function of expense
method:
Net sales
Gross sales P 2,463,500
Less: Sales returns and allowances P 27,500
Sales discounts 42,750 70,250
Net sales P 2,393,250
Cost of sales
Merchandise inventory, 1/1/2019 P528,000
Purchases P1,264,000
Less: purchases returns and allows. P56,400
Purchases discounts 21,360 77,760
Net purchases P1,186,240
Transportation In 82,360
Net cost of purchases 1,268.600
Goods available for sale P1,796,600
Less: merchandise inventory, 12/31/2019 483,000
Cost of sales 1,313,600
Gross profit P1,079,650
Operating expenses
Selling expenses
Sales salaries P225,000
Transportation out 57,400
Store supplies expense 15,400
Insurance expense –selling 5,600
Total selling expenses P 303,400
Administrative expenses
Office salaries P171,000
Utilities expense 48,000
Depreciation expense-building 26,000
Depreciation expense- OE 22,000
Office supplies expense 12,040
Insurance expense –general 3,600
Total administrative expenses P282,640
Total operating expenses 586,040
Operating profit P 493,610
Finance costs 38,400
Profit P455,210
========
Exhibit 7-2 Income Statement (using the function of expense method)
Balance Sheet
The balance sheet dated “December 31, 2019” is implicitly understood to mean “at the close
of business on December 31, 2019”
Assets
Current Assets
Cash P 304,500
Accounts Receivable 484,200
Merchandise Inventory 483,000
Store Supplies 10,600
Office Supplies 6,360
Prepaid Insurance 4,600
Total current assets P 1,293,260
Property and Equipment (net)
Land P 145,000
Building P 202,600
Less: Accumulated Depreciation 82,500 120,100
Office Equipment P 86,000
Less: Accumulated Depreciation 50,000 36,000
Total Property and Equipment P 301,100
Total Assets P1,594,360
==========
Liabilities
Current Liabilities
Accounts Payable P 206,830
Salaries Payable 20,000
Interest Payable 38,400
Total current liabilities P 265,230
Non-Current Liabilities
16% Notes Payable, Due on June 30, 2021 480,000
Owner’s Equity
The adjusting entries are journalized and posted to the ledger as they would be in a service
entity. The closing entries for G. Detoya Traders under the closing entry method appear in
exhibit 7-5.
Note that merchandise inventory is credited in the 1 st entry for the amount of the beginning
inventory, P528,000; and debited in the 2nd entry for the ending inventory, P483,000. Except
for the closing of the temporary accounts typical of a merchandising business, the closing
procedures are the same with that of a service business.
Exhibit 7-5
Closing Entries for G. Detoya Traders: Closing Entry Method
Journal
Date Account Titles and Explanation PR Debit Credit
2019
Dec. 31 Merchandise Inventory, End 483,000
Sales 2,463,500
Purchases returns & allowances 56,400
Purchases discounts 21,360
Income Summary 3,024,260
To close temporary accounts with credit
balances and to establish the ending
merchandise inventory.
Dec. 31 Income Summary 2,569,050
Merchandise Inventory Beg. 528,000
Sales Returns & Allowances 27,500
Sales discounts 42,750
Purchases 1,264,000
Transportation In 82,360
Sales salaries expense 225,000
Office salaries expense 171,000
Store supplies expenses 15,400
Office supplies expenses 12,040
Insurance expense-selling 5,600
Insurance expense –general 3,600
Transportation out 57,400
Utilities expense 48,000
Depreciation expense –store equipment 26,000
Depreciation expense – office equipment 22,000
Interest expense 38,400
To close temporary accounts with debit balances
and to remove beginning inventory
Dec. 31 Income Summary 455,210
G. Detoya, Capital 455,210
To close the income summary account.
Dec. 31 G. Detoya, Capital 200,000
G. Detoya, witdrawals 200,000
To close the withdrawals account.
A final trial balance is prepared to test the equality of the accounts after posting the adjusting
and closing entries. This trial balance is similar to the one discussed in the service business
except for the addition of the merchandise inventory account.
Cash P 304,500
Accounts Receivable 484,200
Merchandise Inventory 483,000
Store Supplies 10,600
Office Supplies 6,360
Prepaid insurance 4,600
Land 145,000
Building 202,600
Accumulated Depreciation –Building P 82,500
Office Equipment 86,000
Accumulated Depreciation –Office Equipment 50,000
Accounts Payable 206,830
Salaries Payable 20,000
Interest Payable 38,400
Long-term Notes Payable 480,000
G. Detoya, Capital 849,130
P1,726,860 P1,726,860
========= =========
Multiple Choice
1. Jan Cahilig Traders started operating in 2019. For the year ended 2019, the sales,
purchases and closing inventory are P500,000, P200,000 and P10,000 respectively.
What is the amount of cost of goods sold for the year ended 2019?
a. P190,000
b. P200,000
c. P790,000
d. P800,000
2. Refer to Question 1, what is the gross profit for the entity?
a. P200,000
b. P300,000
c. P310,000
d. P490,000
3. Based on the following information, answer questions 3 to 7
An entity has the following accounting information for the year:
Sales 400,000
Purchases 90,000
Opening Inventory 30,000
Sales Returns 80,000
Purchases Returns 70,000
Transportation In 40,000
Transportation Out 10,000
Salaries 9,000
Other revenues 4,000
General expenses 7,000
Gross profit 250,000
What is the amount of net sales of the entity?
a. P260,000
b. P280,000
c. P320,000
d. P330,000
4. What is the amount of net purchases of the entity?
a. P20,000
b. P30,000
c. P50,000
d. P60,000
5. What is the amount of closing inventory of the entity?
a. P10,000
b. P20,000
c. P30,000
d. P40,000
6. What is the amount of profit for the year?
a. P48,000
b. P188,000
c. P198,000
d. P228,000
7. Which of the following is/are not relevant to the calculation of net sales?
1. cash sales
2. sales returns
3. sales discounts
a. (2) only
b. (3) only
c. (1) and (2) only
d. (2) and (3) only
8. Suppose RJ Garciano Sound had sales of P300,000 and sales returns of P40,000. Cost
of goods sold was P160,000. How much gross profit did RJ Garciano Sound report?
a. P160,000
b. P180,000
c. P100,000
d. P260,000
9. On a worksheet for a merchandising entity that uses the perpetual inventory system,
a. The cost of goods sold is contained in one account in the Balance Sheet
columns.
b. The cost of goods sold is contained in one account in the Income Statement
columns.
c. The cost of goods sold is created by an entry in the adjustments columns.
d. The items composing cost of goods sold are scattered the Income Statement
columns.
10. Which of the following accounts is closed by debiting the account?
a. Purchases
b. Purchases Returns and allowances
c. Sales Returns and allowances
d. Transportation In
EVALUATION: QUIZ
CHAPTER 8 Manufacturing Operations
Learning Objectives:
Two accounting systems may be used in accounting for manufacturing activities –cost and
non-cost. The cost system keeps perpetual records of the costs of raw material, work in
process and finished goods inventories. This system provides more timely information about
those inventories and changes in their levels. It also produces timely information about
manufacturing costs per unit of product which managers use in their efforts to control costs.
Accounting for manufacturing activities using cost systems is the subject of course in higher
accounting.
The non-cost system produces a manufacturing accounting system based on the periodic
inventory system. The costs of raw materials, work in process and finished goods inventories
are based on physical counts of the quantities on hand at the end of each period. This
information is then used to compute the amounts consumed, finished and sold during the
period. This system does not provide for a detailed flow of costs in the manufacturing process.
In the discussion to follow, the non-cost system will be used. it is also assumed that the entity
uses the voucher system. The following are the pro-forma journal entries of the more common
transactions for a manufacturing entity.
In order for a manufacturer to summarize all the transactions that affect the
computation of the cost of goods manufactured, a manufacturing summary account
is maintained. It is credited for the results of the physical count of raw materials
inventory and work in process inventory at the end of the accounting period. The
contra- purchases accounts are also credited to this account. This account is debited
for the beginning balances of raw materials and work in process inventory, and the
manufacturing accounts with debit balances. The balance of the manufacturing
summary account is then closed to the income summary account.
The other closing entries after this procedure are the same as those for a
merchandising entity.
STATEMENT OF COST OF GOODS MANUFACTURED
Total manufacturing costs should not be confused with the cost of goods manufactured.
Total manufacturing costs are the costs of direct materials used, direct labor and
manufacturing overhead incurred and charged to production during an accounting period.
The cost of goods manufactured consists of the total manufacturing costs related to the
products completed during an accounting period. This statement is also called the
manufacturing statement.
A manufacturer produces its own finished goods inventory. Cost of goods manufactured is
the manufacturer’s counterpart to the merchandiser’s bought for resale during the period.
Cost of goods manufactured is the manufacturing cost of the goods completed during a
production period.
Merchandising Entity Manufacturing Entity
Merchandise inventory, beg. Pxx Finished goods inventory, Beg. Pxx
Add: net cost of purchases xx add: Cost of Goods Manufactured xx
Goods available for sales Pxx Goods available for sale Pxx
Less: merchandise inventory, end xx less: Finished goods inventory, end xx
Cost of goods sold Pxx Cost of goods sold Pxx
=== ===
The worksheet for a manufacturing entity is basically the same as that for a merchandising
entity except that it includes a pair of columns for cost of goods manufactured. All the
accounts that comprise the statement of cost of goods manufactured are extended to these
columns. Beginning raw materials inventory and work in process are debited in the
manufacturing columns while the related ending inventories are credited.
The other manufacturing accounts are either debited or credited as necessary. The
difference between the total debits and total credits of these two columns is then extended
to the debit column of the income statement. Beginning finished goods inventory being a
component in the computation of cost of goods sold is extended to the debit side of the
income statement columns while the ending finished goods inventory to the credit column.
Multiple Choice
EVALUATION:
HOMEWORK
QUIZ
CHAPTER 10: Accounting for Payroll
Learning Objectives:
Definition of Terms
Employee refers to any individual who is a recipient of salaries or wages. It includes an officer,
employee or elected official of the Government of the Philippines or any political subdivision,
agency or instrumentality thereof. The term also includes an officer of a corporation.
Employer means a person for whom an individual performs or performed any service, of
whatever nature, as the employee of such person.
Payroll refers to the total amount paid to employees for services provided during a period.
Payroll period means a period for which an employer ordinarily makes payment of salaries or
wages to the employees.
Gross Pay
Salaries or wages means all remuneration paid for services performed by an employee for his
employer, including the cash value of all remuneration paid in any medium other than cash.
The term salary is usually applied to managerial, supervisory and administrative services. The
rate of salary is expressed in terms of a month or a year. Remuneration for skilled or unskilled
labor is ordinarily referred to as wages; the rates are stated on an hourly or piecemeal basis.
Commissions, bonuses, cost of living allowance and fringe benefits may increase the basic
salary or wage of an employee. The total earnings of an employee for a payroll period before
taxes and other deductions are taken out, is called gross pay.
Salary and wage rates are determined, in general, by agreement between the employer
and the employee subject to the Minimum Wages Law and the Labor Code of the Philippines.
Regular working hours shall not be more than eight hours in any one day nor more than 40
hours in any one week. Employees who worked for more than 8 hours a day should be paid
an additional compensation generally equivalent to regular pay plus at least 25%.
Every employee shall be paid a night shift differential of not less than 10% of his regular pay
for each hour of work performed between ten o’clock in the evening and six o’clock in the
morning. Work on Sundays calls for overtime pay at a premium of 30% while work on holidays
requires a 100% premium. For purposes of computing overtime and other additional
remuneration, the regular pay shall include only cash payments.
Employee Benefits
Private employees, whether permanent, temporary or provisional, who is not over 60 years
old, is subject to compulsory coverage under the Social Security System (SSS) and the
National Health Insurance Program (NHIP) and the Pag-IBIG fund. Employers who avail of the
services of another person in business, trade, industry or any undertaking must also be
registered with the SSS, NHIP and Pag-IBIG fund.
Covered employees are entitled to a package of benefits under the Social Security and
Employee’s Compensation in case of death, disability, sickness, maternity and old age. The
SSS administers the two programs, namely: the Social Security Program and the Employee’s
Compensation Program.
The Social Security System provides for a replacement of income lost on account of the
aforementioned contingencies. The benefits under the program are as follows: sickness,
maternity, disability, retirement and death benefits.
Although the SSS was mandated primarily to give social security protection, it has also
provided its members with loan programs from which the members can borrow for personal
purposes. These loans may be used for the member’s or his dependents’ education; or for
the purchase of stock investments in privatized government owned and controlled
corporations.
Recently, the SSS has required employers to serve as guarantors of their employees applying
for salary loans and cut down its repayment period from two years to one year. The employer
would be liable to pay the balance should the borrower resign or transfer to another
company.
Self- employed and voluntary members, who have no employer’s would need another
member of good standing to serve as co-maker of their loan application. The co-maker
would be liable If the self-employed or voluntary member reneged on the loan.
The Employees’ Compensation (EC) Program aims to assist workers who suffer work-related
sickness or injury resulting in disability or death. The benefits under the EC program may be
enjoyed simultaneously with benefits under the social security program. All SSS –registered
employers and their employees are compulsorily covered under this program. The benefits
under the EC program are as follow: medical services and supplies, rehabilitation services
and income cash benefit for temporary total disability or sickness, permanent total or partial
disability, and death.
The National Health Insurance Program (NHIP), formerly known as the Medicare, is a health
insurance program for SSS members and their dependents whereby the healthy subsidize the
sick who may find themselves in need of financial assistance when they get hospitalized.
The program aims to provide medical care residents of the country in an evolutionary way
within our economic means and capability as a nation. It also aims to provide our people
with a viable means of helping themselves pay for adequate medical care. The Philippine
health Insurance Corporation of Philhealth is the mandated administrator of the Medicare
program under the National Health Insurance Act of 1995. The benefits under the NHIP for a
single period of confinement are as follows: room and board, medical expenses (drugs and
medicines, laboratory charges), operating room fees for surgical procedures, medical and
dental practitioners’ fee, surgeon’s fee, anesthesiologist’s fees and fees for surgical family
planning procedures.
Effective July 1, 1999, Medicare collection and membership functions being performed by
the SSS for the private sector members shall now be assumed by Philhealth.
The Pag-IBIG Fund promotes home ownership through the establishment of an affordable
and adequate housing credit system for its members. It also provides small and short-term
loans. The members upon termination of membership will also receive the accumulated
dividend benefit. The Pag-IBIG Fund promotes the benefits of home ownerships and savings.
Membership in the fund is mandatory upon all employees covered by the Social Security
System and the Government Services Insurance System, and their respective employers.
However, the coverage of employees whose monthly compensation is less than P4,000 shall
be voluntary.
Every employer making payment of wages shall deduct and withhold upon such
wages a tax determined in accordance with the rules and regulations prescribed by
the Secretary of the department of Finance, upon recommendation of the
Commissioner of the Bureau of Internal Revenue.
Withholding taxes are applied on gross pay after deducting the mandatory employee
contributions and other non-taxable benefits. According to Section 32(B) (7) (f) of the
tax Reform Act of 1997, GSIS or SSS, Medicare (now Philhealth) and Pag-IBIG
contributions and union dues of individuals are excluded from gross income effective
January 1, 1998.
Withholding tax tables are available for various periods, such as daily, weekly semi-
monthly and monthly. The revised withholding tax table under the TRAIN LAW
(effective Jan. 1, 2018 to Dec. 31, 2022) is given for illustrative purposes.
Net Pay
Gross pay for a payroll period less the payroll deductions – SSS, Philhealth, and Pag-IBIG
contributions of the employee; withholding taxes; union dues and other deductions- equals
net pay. Net pay or take-home pay is the amount to be paid to the employee.
Expenditures for labor costs and related payroll expenses are usually significant for most
business entities for several reasons:
Time Cards
A payroll system should include an accurate and reliable record of the employees’ work
hours during a particular payroll period. Employee time records are usually maintained in
time cards.
Time cards may be filled in either manually or through time clocks. Both systems record the
daily arrival and departure times of each employee. A typical time card has three sections
to keep track of employees’ in and out time in the morning, afternoon and overtime; and
another section to summarize the hours worked – regular and overtime.
Payroll Register
Each pay period, the entity organizes the payroll data in a special journal called the payroll
register. This register lists each employee and the related payroll amounts. This journal also
serves as the basis for preparing the payroll journal entries.
The register can have major sections for employees’ names, tax status, total hours worked,
gross pay, total deductions and net pay. The gross pay section may have columns for regular,
overtime pay and total earnings for each employee. Deductions include the SSS, Philhealth
, Pag-IBIG, withholding taxes, advances and other authorized deduction. The net pay section
lists each employee’s take-home pay and if payroll is paid through checks, the number of
the check issued to the employee.
Each employer must keep a detailed record of earnings and withholdings for each employee
in an employee earnings record. This form is designed to help the employer meet various
reporting requirements. The sections of this record are the same as that of a payroll register;
however, the record maintains a cumulative gross pay column and additional data on
employment specifics like SSS number, Philhealth identification number, taxpayer’s
identification number, pay rate, date of employment and tax status.
If payments of salaries or wages are made in cash, payroll slips should be prepared for every
payroll period. A pay slip is prepared for each employee; each slip contains the pertinent
payroll figures found in the payroll register. The employee upon receipt of cash signs this slip
and a duplicate copy is given to him.
Most employers with a large number of employees use a special bank account to disburse
paychecks to employees. Other employers do away with writing numerous checks and
instead pay their employees through their automated teller machine (ATM) accounts. The
bank is simply notified of the amounts to be credited to the account of each employee.
Payroll Entries
The following summarizes the employer’s entries to record the semi-monthly payroll of
P116,500 for the period Oct.16 to 31, 2018. The amounts used in the first entry are lifted directly
from the payroll register. The second entry recorded the cash payment to the employees.
The third entry presented the employer’s payroll expenses. Note that the contributions are
based on a semi-monthly payroll as explained in the notes to the payroll register (to be found
at the end of the chapter.) Entries for the remittances will entail debits to payables and
credits to cash in bank on specific dates.
2018
Oct. 31 Salaries Expense 116,500
SSS and EC Contributions Payable 2,543.20
Phil-health contribution payable 1,464,37
Pag-IBIG contribution payable 450.00
Withholding taxes payable 7,085.49
Salaries payable 104,956.94
To record payroll for the month
Remittances
The employer shall collect contributions of members through payroll deductions. At certain
dates, the employer is required to remit the employees’ contributions along with his
counterpart contributions.
The SSS, Phil-health and Ec contribution should be remitted by the employer on or before the
10th day of the month following the applicable month if the payment is to be done through
the electronic data interchange (EDI). If the payment is to be made over the counter, the
remittance should be made on or before the last day of the applicable month. The SSS has
phased out the acceptance of over-the-counter payments at the SSS main office.
When sending remittances through the bank, it is important to secure the duplicate copy of
the special bank receipt (SBR) and the original copy of the SSS form R5 (monthly contributions
payment return) issued by the bank for these would serve as the official receipt. At the end
of the quarter, the three form R5s and SBRs collected for past three months will be submitted
along with SSS form R3 (quarterly collection list).
In the case of Pag-IBIG contributions, the employer shall remit to the fund the contributions
as well as those of the covered employees on specific days of the month based on the initial
letter of the employer’s business name. employers with names starting with letters A to D will
have payment due dates on the 10th to the 14th day of the month; E to L 15th to the 19th ; M
to Q 20th to the 24th ; and R to Z 25th to the end of the month.
Taxes deducted and withheld by the employer on salaries or wages of employees shall be
covered by a return and paid on or before the 10th day of the month following the month in
which withholding was made. For taxes withheld on compensation for the month of
December, not later than January 15 of the following year.
Chapter 11: Partnerships: Basic Considerations and Formation
Learning Objectives:
DEFINITION
An association of two or more persons to carry on, as co-owners, a business for profit
(uniform partnership act, section 6)
The partnership has a juridical personality separate and distinct from that of each of the
partners (civil code of the Philippines, article 1768). Thus, for example, where Vincent
Fabella and Wilhelmina Neis established a partnership, three persons are involved,
namely: the partnership and the partners, Fabella and Neis.
Partnership resemble sole proprietorships, except that there are two or more owners of
the business. Each owner is called a partner. Partnerships are often formed to bring
together various talents and knowledge. Partnerships provide a means of obtaining more
equity capital than a single individual can obtain and allow the sharing of risks for rapidly
growing businesses.
The characteristics of partnership are different from the sole proprietorships already
studied in basic accounting. Some of the more important characteristics are as follows:
Division of Profits or Losses. The essence of partnership is that each partner must share in
the profits or losses of the venture.
Co- Ownership of Contributed Assets. All assets contributed into the partnership are
owned by the partnership by virtue of its separate and distinct juridical personality. If one
partner contributes an asset to the business, all partners jointly own it in a special sense.
Mutual Agency. Any partner can bind the other partners to a contract if he is acting
within his express or implied authority.
Limited Life. A partnership has a limited life. It may be dissolved by the admission, death,
insolvency, incapacity, withdrawal of a partner or expiration of the term specified in the
partnership agreement.
Unlimited Liability. All partners (except limited partners), including industrial partners, are
personally liable for all debts incurred by the partnership. If the partnership cannot settle
its obligations, creditors’ claims will be satisfied from the personal assets of the partners
without prejudice to the rights of the separate creditors of the partners.
Income Taxes. Partnership, except general professional partnerships, are subject to tax
at the rate of 30% (per R.A no. 9337) of taxable income.
Partners’ Equity Accounts. Accounting for partnerships are much like accounting for sole
proprietorships. The difference lies in the number of partners’ equity accounts. Each
partner has a capital account and a withdrawal account that serves similar functions as
the related accounts for sole proprietorships.
Disadvantages
1. Easily dissolved and thus unstable compared to a corporation.
2. Mutual agency and unlimited liability may create personal obligations to partners.
3. Less effective than a corporation in raising large amounts of capital.
Number of Persons. Two or more persons may form a partnership; in a corporation, at least
five (5) persons, not exceeding fifteen (15).
Extent of Liability. In a partnership, each of the partners except a limited partner is liable to
the extent of his personal assets; in a corporation, stockholders are liable only to the extent of
their interest or investment in the corporation.
Terms of Existence. In a partnership, for any period of time stipulated by the partners; as a
corporation, not to exceed fifty (50) years but subject to extension.
CLASSIFICATIONS OF PARTNERSHIPS
1. According to object:
A. Universal partnership of all present property. All contributions become part of
the partnership fund.
B. Universal partnership of profits. All that the partners may acquire by their
industry or work during the existence of the partnership and the use of
whatever the partners contributed at the time of the institution of the contract
belong to the partnership. If the articles of universal partnership did not specify
its nature, it will considered a universal partnership of profits.
C. Particular partnership. The object of the partnership is determinate – its use or
fruit, specific undertaking, or the exercise of a profession or vocation.
2. According to liability:
A. General. All partners are liable to the extent of their separate properties.
B. Limited. The limited partners are liable only to the extent of their personal
contributions. In a limited partnership, the law states that there shall be at least
one general partner.
3. According to duration:
A. Partnership with a fixed term or for a particular undertaking.
B. Partnership at will. One in which no term is specified and is not formed for any
particular undertaking.
4. According to purpose:
A. Commercial or trading partnership. One formed for the transaction of business.
B. Professional or non-trading partnership. One formed for the exercise of
profession.
5. According to legality of existence:
A. De jure partnership. One which has complied with all the legal requirements
for its establishment.
B. De facto partnership. One which has failed to comply with all the legal
requirements for its establishment.
KINDS OF PARTNERS
1. General partner. One who is liable to the extent of his separate property after all the
assets of the partnership are exhausted.
2. Limited partner. One who is liable only to the extent of his capital contribution. He is
not allowed to contribute industry or services only.
3. Capitalist partner. One who contributes money or property to the common fund of
the partnership.
4. Industrial partner. One who contributes his knowledge or personal service to the
partnership.
5. Managing partner. One whom the partners has appointed as manager of the
partnership.
6. Liquidating partner. One who is designated to wind up or settle the affairs of the
partnership after dissolution.
7. Dormant partner. One who does not take active part in the business of the partnership
and is not known as a partner.
8. Silent partner. One who does not take active part in the business of the partnership
though may be known as a partner.
9. Secret partner. One who takes active part in the business but is not known to be a
partner by outside parties.
10. Nominal partner or partner by estoppel. One who is actually not a partner but who
represents himself as one.
ARTICLES OF PARTNERSHIP
SEC REGISTRATION
When the partnership capital is P3,000 or more, in money or property, the public instrument
must be recorded with the Security and Exchange Commission (SEC). Even if it not registered,
the partnership having a capital of P3,000 or more is still valid and therefore has legal
personality.
The SEC shall not registered any corporation organized for the practice of public
accountancy (The Philippine Accountancy act of 2004, sec. 28).
The purpose of the registration is to set “a condition for the issuance of the licenses to engage
in business or trade. In this way, the tax liabilities of big partnerships cannot be evaded, and
the public can also determine more accurately their membership and capital before dealing
with them. “
To register a partnership with the SEC, here are the basic steps to follow:
• Have your proposed business name verified in the verification unit of SEC
The partnership name shall bear the word “Company” or “Co.” and if it’s a limited
partnership, the word “Limited “ or “Ltd.” A professional partnership may bear the word
“Company,” “ Associates” or “Partners” or other similar descriptions. (SEC
memorandum circular 5, series 2008).
For partnership with foreign partners: SEC form F-105, bank certificate on the
capital contribution of partners, proof of remittance of contribution of foreign
partners;
• Pay the registration/filling and miscellaneous fees: filling fee equivalent to 1/5 of 1% of
the partnership capital but not less than P1,000 and legal research fee which is 1% of
the filling fee;
• Forward documents to the SEC Commissioner for signature
ACCREDITATION TO PRACTICE PUBLIC ACCOUNTANCY
Certified public accountants (CPAs), firms and partnerships of CPAs, engaged in the
practice of public accountancy, including the partners and staff members thereof,
shall register with the Professional Regulation Commission and the Professional
regulatory board of Accountancy. The registration shall be renewed every three years
(the Philippines accountancy act of 2004, sec.31). the rules and regulations covering
the accreditation for the practice of public accountancy are specified in annex B of
the rules and regulation implanting republic act 9298 otherwise known as the
Philippine accountancy act of 2004.
In the earlier chapters of this book, generally accepted accounting principles were
discussed in the context of a sole proprietorship. These accounting principles also
apply to a partnership. Thus, the recording of assets, liabilities, income and expenses
is consistent for both proprietorships and partnerships. Comparing two businesses of
the same nature, one organized as a sole proprietorship and another as a partnership,
there will be no marked difference in their operations.
However, differences arise between the two forms of business concerning owners’
equity. For a proprietorship, there is only a single owner. Therefore, there is only one
capital account and one drawing account. On the other hand, since a partnership
has two or more owners, separate capital and drawing accounts are established for
each partner.
A partner’s capital account is credited for his initial and additional net investments
(assets contributed less liabilities assumed by the partnership), and credit balance of
the drawing account at the end of the period. It is debited for his permanent
withdrawals and debit balance of the drawing account at the end of the period.
Typically, partners do not wait until the end of the year to determine how much of the
profits they wish to withdraw from the partnership. To meet personal living expenses,
partners customarily withdraw money on a periodic basis throughout the year. A
partner’s drawing account is debited to reflect assets temporarily withdrawn by him
from the partnership. At the end of each accounting period, the balances in the
drawing accounts are closed to the related capital accounts.
The use of drawing accounts for temporary withdrawals provides a record of each partner’s
drawings during an accounting period. Hence, drawings in excess of the allowed amounts
as stated in the partnership agreement may be controlled.
Notice that profit (or loss) is credited (or debited) either to the drawing account to the capital
account. The choice of the account to credit or debit depends on the intention of the
partners. If they wish to maintain their capital accounts for investments and permanent
withdrawals, then profit or loss should be entered in the drawing account.
On the other hand, if the purpose of the partners is to make profit or loss part of their capital,
then the capital account should be used. in either case, the resulting partners’ ending capital
balance will be the same.
If a partner withdraws a substantial amount of money with the intention of repaying it, the
debit should be to loans receivable-partner account instead of to partner’s drawing
account. This account should be classified separately from the other receivables of the
partnership.
A partner may lend amounts to the partnership in excess of his intended permanent
investment. These advances should be credited to loans payable-partner account and not
to partner’s capital account classified among the liabilities but separate from liabilities to
outsiders. This distinction is important in case of liquidation. Loans payable to partners must
be paid after the claims of outside creditors have been paid in full.
These loans have priority over partners’ equity.
PARTNERSHIP FORMATION
The books of the partnership are opened with entries reflecting the net contributions of the
partners to the firm. Asset accounts are debited for assets contributed to the partnership,
liability accounts are credited for any liabilities assumed by the partnership and separate
capital accounts are credited for the amount of each partner’s net investment (asset less
liabilities).
Partners may invest cash or non-cash assets in the partnership. When a partner invests non-
cash assets, they are to be recorded at values agreed upon by the partners. In the absence
of any agreement, the contributions will be recognized at their fair market values at the date
of transfer to the partnership.
The fair market value of an asset is the estimated amount that a willing seller would receive
from a financially capable buyer for the sale of the asset in a free market. Per international
financial reporting standards (IFRS) no. 3, fair value is the price at which an asset or liability
could be exchanged in a current transaction between knowledgeable, unrelated willing
parties.
Adjustment of Accounts Prior to Formation
In cases when the prospective partners have existing businesses, their respective books will
have to be adjusted to reflect the fair market values of their assets or to correct misstatements
in the accounts. If the adjustments will not be made, the initial capital balances of the
partners may be inequitable.
The adjustments of the assets and liabilities prior to formation will be similar to the adjustments
that we are already familiar with. However, when the adjustment involves a debit or credit
to a nominal account, the capital account would instead be debited or credited. This is so
because the business has ceased to be a going concern. A business is not viewed as a going
concern if liquidation appears imminent. For example, two sole proprietorships will cease
operations because of their agreement to enter into a partnership. Both proprietorships have
ceased to be a going concerns.
Illustration. Emerita Geron and Emerita Modesto formed a general professional partnership.
Emerita Geron will invest sufficient cash to get an equal interest in the partnership while
Emerita Modesto will transfer the assets and liabilities of her business. The account balances
on the books of Modesto prior to partnership formation follows:
Debit credit
Cash 180,000
Accounts receivable 300,000
Office equipment 1,500,000
Accumulated depreciation 600,000
Accounts payable 155,000
Salaries payable 25,000
Emerita Modesto, Capital 1,200,000
It is agreed that for purposes of establishing Emerita Geron’s interest, the following
adjustments shall be made in the books of Emerita Modesto:
2. An omission to record the asset –prepaid expenses will denote that the expenses of
the business are overstated. When the expenses are overstated, profit and
correspondingly the owner’s equity is understated. To recognize the prepaid
expense, the entry will be:
Prepaid expenses 30,000
Emerita Modesto, capital 30,000
The opening entry to recognize the contributions of each partner into the partnership is simply
to debit the assets contributed, and to credit the liabilities assumed and the capital account
of each partner.
Illustration. On July 1, 2019, Nilo Burgos and Rey Fernan Refozar agreed to form a partnership.
The partnership agreement specified that Burgos is to invest cash of P700,000 and Refozar is
to contribute land with a fair market value of P1,300,000 with P300,000 mortgage to be
assumed by the partnership. The entries are as follows:
Cash 700,000
Land 1,300,000
Mortgage payable 300,000
Nilo Burgos, Capital 700,000
Rey Fernan Refozar, Capital 1,000,000
After the formation, the statement of financial position of the partnership is:
Assets
Cash P 700,000
Land 1,300,000
Total Assets P2,000,000
=========
Liabilities and Owners’ Equity
Illustration. Suppose that Burgos and Refozar formed another partnership with Nora Elizabeth
Maniquiz. Burgos and Refozar considered Maniquiz who has a vast business network in Bicol
as an industrial partner. The partnership did not receive any asset from Maniquiz. In this case,
only a memorandum entry in the general journal will be made.
A sole proprietor may consider forming a partnership with an individual who has no existing
business. Under this type of formation, the assets and the liabilities of the proprietor will be
transferred to the newly formed partnership at values agreed upon by all the partners or at
their current fair prices.
Illustration. The statement of financial position of Leopoldo Medina on Oct. 1, 2019, before
accepting John Karlo Dalangin as partner is shown as follows:
Leopoldo Medina
Statement of Financial Position
Oct.1, 2019
Assets
Cash P 60,000
Notes Receivable 30,000
Accounts Receivable P240,000
Less: Allowance for uncollectible accounts 10,000 230,000
Merchandise Inventory 80,000
Furniture and Fixtures P 60,000
Less: accumulated depreciation 6,000 54,000
Total assets P 454,000
========
Liabilities and Owner’s Equity
Notes payable P 40,000
Accounts payable 100,000
Leopoldo Medina, Capital 314,000
Total liabilities and Owner’s Equity P 454,000
========
John Karlo Dalangin offered to invest cash to get a capital credit equal to one-half of
Leopoldo Medina’s capital after giving effect to the adjustments below. Del mundo
accepted the offer.
1. The merchandise is to be valued at P74,000.
2. The accounts receivable is estimated to be 95% collectible.
3. Interest accrued on the notes receivable will be recognized: P10,000, 12% dated
July 1, 2019 and P20,000, 12% dated August 1, 2019.
4. Interest on notes payable to be accrued at 14% annually from April 1.
5. The furniture and fixtures are to be valued at P46,000.
6. Office supplies on hand that have been charged to expense in the past
amounted to P4,000. These will be used by the partnership.
New books for the Partnership (required per National Internal Revenue Code)
The following procedures may be used in recording the formation of the partnership:
(2)
Notes payable 40,000
Accounts payable 100,000
Interest payable 2,800
Allowance for Uncollectible accounts 12,000
Accumulated depreciation 14,000
Leopoldo Medina, Capital 299,900
Cash 60,000
Notes receivable 30,000
Accounts receivable 240,000
Interest receivable 700
Merchandise Inventory 74,000
Offices supplies 4,000
Furniture and Fixtures 60,000
To close the books of Medina.
Computations:
After the formation, the statement of financial position of the newly formed partnership is:
Assets
Cash P209,950
Notes Receivable 30,000
Accounts Receivable P240,000
Less: Allowance for Uncollectible accounts 12,000 228,000
Interest Receivable 700
Merchandise Inventory 74,000
Offices Supplies 4,000
Furniture and fixtures 46,000
Total Assets P592,650
=======
Note that furniture and fixtures are now recorded in the partnership books at the agreed
amount of P46,000 which represented the cost of the asset to the partnership. On the other
hand, the accounts receivable is still recorded at gross amount of P240,000 with a related
allowance for uncollectible accounts of P12,000. The P12,000 is only a provision for possible
uncollectible.
Illustration. On June 30, 2019, Deogracia Corpuz and Esterlina Gevera, friendly competitors
in a certain line of business, decided to combine their talents and capital to form a
partnership. Their statements of financial position are as follows:
Deogracia Corpuz
Statement of Financial Position
June 30, 2019
Assets
Cash P 50,000
Accounts Receivable 100,000
Merchandise Inventory 80,000
Furniture and Fixture 60,000
Total Assets P290,000
=======
Liabilities and Owners’ Equity
Accounts Payable P 30,000
Deogracia Corpuz, Capital 260,000
Total liabilities and Owners’ Equity P290,000
========
Esterlina Gevera
Statement of Financial Position
June 30, 2019
Assets
Cash P 40,000
Accounts Receivable 80,000
Merchandise Inventory 100,000
Delivery Equipment 90,000
Total Assets P310,000
=======
Liabilities and Owners’ Equity
Accounts Payable P 60,000
Esterlina Gevera, Capital 250,000
Total liabilities and Owners’ Equity P310,000
========
The conditions and adjustments agreed upon by the partners for purposes of determining
their interests in the partnership are:
New books for the Partnerships (required per National Internal revenue Code)
The following procedures may be used in recording the formation of the partnership:
(2)
Accounts payable 30,000
Allowance for uncollectible 10,000
Accumulated depreciation 6,000
Deogracia Corpuz, Capital 240,500
Cash 46,500
Accounts receivable 100,000
Merchandise inventory 80,000
Furniture and Fixtures 60,000
To close the books of Corpuz.
(2)
Accounts payable 60,000
Allowance for uncollectible accounts 8,000
Accumulated depreciation 9,000
Esterlina Gevera, Capital 243,000
Cash 40,000
Accounts Receivable 80,000
Merchandise inventory 110,000
Delivery equipment 90,000
To close the books of Gevera.
(2)
Cash 40,000
Accounts Receivable 80,000
Merchandise inventory 110,000
Delivery Equipment 81,000
Accounts Payable 60,000
Allowance for uncollectible accounts 8,000
Esterlina Gevera, Capital 243,000
To record the investment of Gevera.
After the formation, the Statement of financial position of the newly formed partnership is:
Assets
Cash P 86,500
Accounts Receivable P180,000
Less: Allowance for uncollectible account 18,000 162,000
Merchandise Inventory 190,000
Furniture and Fixtures 54,000
Delivery Equipment 81,000
Total Assets P573,500
=======
Liabilities and Owners’ Equity
Accounts Payable P 90,000
Deogracia Corpuz, Capital 240,500
Esterlina Gevera, Capital 243,000
Total Liabilities and Owners’ Equity P573,500
=======
Multiple Choice:
1. Pentrante owns and operates a large hardware store in Cabanatuan City that
employs about forty-five personnel. She delegates some of the decision making to
two supervisors. Penetrante’s business is organized as a
a. Corporation
b. Partnership
c. Sole proprietorship
d. Limited partnership
2. Jumawan loves to cook. She receives unqualified praise whenever she prepares a
meal for someone. Encouraged by these compliments and eager to put her culinary
talents to good use, Jumawan decides to open a boutique restaurant in Dumaguete
City. Since she plans to maintain complete control of the business, she will most likely
organize it is a
a. Limited partnership
b. Corporation
c. General partnership
a. Sole proprietorship
2. A budding entrepreneur wants to start a business but is unsure of the legal form suited
for her. Short of cash, she has to take the form that is least expensive and most flexible
in terms of decision making and implementation. Which would you recommend?
a. Joint venture
b. Partnership
c. Sole proprietorship
d. Cooperative
e. Corporation
EVALUATION:
QUIZ
Learning Objectives:
The basis on which profits or losses are shared is a matter of agreement among the partners
and may not necessarily be the same as their capital contribution ratio. The equity of a
partner in the net assets of the partnership should be distinguished from a partner’s share
profits or losses.
Partnership profits are realized as a result of putting together the contribution –money,
property or industry-of the partners. The amount of capital invested by each partner, the
amount of time each partner devotes to the business and other contributions are the factors
being considered in the formulation of an equitable profit and loss ratio.
There are profit-sharing plans which emphasize either the value of personal services rendered
by individual partners or the amounts of capital invested by each partner. Some agreements
consider the importance of both the amount and quality of managerial services rendered,
and the amount of capital invested by the partners for the success or failure of a partnership.
In this case, allowances may be provided for salaries to partners and interest on their
respective capital balances as a preliminary step in the division of profits or losses; the
balance may then be divided in a specified ratio. Among the other factors which may be
considered are as follows:
1. A partner has considerable personal financial resources, thus giving the partnership a
strong credit rating. In general, partners have unlimited liability. A very solvent partner
will make the partnership attractive to creditors.
2. A partner who is well known in a profession or an industry may contribute immensely
to the success of the partnership although he may not participate actively in the
operations of the partnership.
These two factors may be incorporated in the plan to arrive at a ratio by which any remaining
profits or losses are to be divided.
Illustration. Daria Tolentino and Eleonor Tan are partners in a coco water business. Partner
Daria Tolentino contributed most of the assets of the business but spends little time for its daily
operations. On one hand, Partner Eleonor Tan contributed less in assets but devotes her full
knowledge and attention to the partnership. To divide profits or losses based on capital
contributions alone will result to inequities. The profit and loss sharing agreement should have
considered the provision of salaries or even bonus in recognition of the talent and time being
contributed by Partner Eleonor Tan.
Performance Methods
Many partnerships use profit and loss sharing arrangements that give some weight to the
specific performance of each partner to provide incentives to perform well. This allocation
of profits to a partner on the basis of performance is frequently referred to as a bonus.
Examples of the use of performance criteria are:
1. Chargeable hours. These are the total number of hours that a partner incurred on
client related assignments. Weight may be given to hours in excess of a standard.
2. Total billings. The total amount billed to clients for work performed and supervised by
a partner constitutes total billings. Weight may be given to billings in excess of norm.
3. Write-offs. Consist of uncollectible billings. Weight may be given to a write-off
percentage below a norm.
4. Promotional and civic activities. Time devoted to developing future business and
enhancing the partnership name in the community is considered promotional and
civic activity. Weight may be given to time spent in excess of a norm or to specific
accomplishments resulting in new clients.
5. Profits in excess of specified levels. Designed partners commonly receive a certain
percentage of profits in excess of a specified level of earnings.
The profits or losses shall be distributed in conformity with the agreement. If only the share of
each partner in the profits has been agreed upon, the share of each in the losses shall be in
the same proportion.
In the absence of stipulation, the share of each partner in profits or losses shall be in proportion
to what he may have contributed (according to the ratio of original capital investments or in
its absence, the ratio of capital balances at the beginning of the year), but the industrial
partner may not be liable for the losses.
As for the profits, the industrial partner shall receive such share as may be just and equitable
under the circumstances. If aside from his services he has contributed capital, he shall also
receive a share in the profits in proportion to his capital (civil code of the Philippines, article
1797). A stipulation which excludes one or more partners from any share in the profits or losses
is void. (article 1799). The partnership must exist for the common benefit or interest of the
partners. A summary of the above legal provisions is prepared as follows:
1. Profits
a. The profits will be divided according to partners’ agreement.
b. If there is no agreement:
2. Losses
a. The losses will be divided according to partners’ agreement.
b. If there is no agreement as to distribution of losses but there is an agreement as
to profits, the losses shall be distributed according to the profit sharing ratio.
c. In the absence of any agreement.
^ as to capitalist partners, the losses shall be divided according to their capital
contributions (according to the ratio of original capital investments or in its
absence, the ration of capital balances at the beginning of the year).
^ as to purely industrial partners (if there’s any), shall not be liable for any losses.
The industrial partner is not liable for losses because he cannot withdraw the work or labor
already done by him, unlike the capitalist partners who can withdraw their capital. In
addition, if the partnership failed to realize any profits, then he has labored in vain and in a
real sense, he has already contributed his share in the loss.
Any business entity will from time to time discover errors made in the measurement of profit in
prior accounting periods. Good internal control and the exercise of due care should serve
to minimize the number of financial reporting errors that occur; however, these safeguards
cannot be expected to completely eliminate errors in the financial statements.
In general, profits or losses shall be divided in accordance with the agreement of the partners.
The ratio in which profits or losses from partnership operations are distributed is recognized as
the profit and loss ratio.
The partners may agree on any of the following scheme in distributing profits or losses:
1. Equally or in other agreed ratio.
2. Based on partners’ capital contributions:
a. ratio of original capital investments
b. ratio of capital balances at the beginning of the year
c. ratio of capital balances at the end of the year
d. ratio of average capital balances
3. By allowing interest on partners’ capital and the balance in an agreed ratio
4. By allowing salaries to partners and the balance in an agreed ratio
5. By allowing bonus to the managing partner based on profit and the balance in an
agreed ratio
6. By allowing salaries, interest on partners’ capital bonus to the managing partner
and the balance in an agreed ratio (combination of 3 to 5)
Note that the partners can agree on not using a residual sharing ratio (“the balance in an
agreed ratio”) if profits do not exceed the total salary and interest allowances. In such a
case, the partners must agree on the priority of the various profit or loss distribution schemes.
Illustration. The following series of illustrations are based on the figures obtained from the
Aguilar and Porras Partnership which had a profit of P300,000 for the year ended December
31, 2019, the first year of operations. The partnership contract provided that each partner
may withdraw P5,000 on the last day of each month; both partners did so during the year.
The drawings are recorded by debits to the partners’ drawing accounts and shall not be
considered in the division of profit or loss. It is the intention of the partners that each partner’s
share in the profit or loss be either credited or debited to the drawing account.
Lord Aguilar invested P400,000 on Jan. 1, 2019 and an additional P100,000 on April 1. Devzon
Porras invested P800,000 on Jan. 1 and withdrew P50,000 on July 1.
Partnership contracts may provide that profit or loss be divided equally. The profit of P300,000
for the Aguilar and Porras Partnership is transferred by a closing entry on December 31, 2019,
from the Income Summary ledger account to the partners’ drawing accounts:
If the partnership had a loss of P200,000 for the year ended December 31, 2019, the income
summary ledger account would have a debit balance of P200,000. This loss would be
transferred to the partners’ drawing accounts by a debit to each drawing account for
P100,000 and a credit to the income summary account for P200,000.
Assume instead that Aguilar and Porras share profits and losses in a ratio of 60:40 and profit
was P300,000, the profit would be divided as follows:
Computation:
Aguilar: 60% x P300,000 = P180,000
Porras : 40% x P300,000 = 120,000
Division of partnership profits in proportion to the capital invested by each partner is most
likely to be found in partnerships in which substantial investments is the principal ingredient for
success. It is essential that the partnership contract be specific with respect to the concept
of capital. Capital may refer to either of the following:
Ratio of Original Capital Investments. Assume that the partnership agreement provides for
the division of profits in the ratio of original capital investments. The original investments of
Aguilar and Porras are P400,000 and P800,000, respectively. The profit of P300,000 for 2019 is
divided as follows:
Computation:
Aguilar: P300,000 x P400,000/P1,200,000 = P100,000
Porras: P300,000 x P800,000/P1,200,000 = 200,000
After the entry allocating the profits of P300,000 to Aguilar and Porras, are the partners
supposed to receive cash for their respective share in the profits? No, the partners share in
the profits cannot be attributed to any particular asset, including cash. The entry increased
the equity of Aguilar and Porras in all the assets of the partnership.
Ration of Capital Balances at the Beginning of the year. Assume that the partnership
agreement provided for the division of profits in the ratio of capital balances at the beginning
of the year. In this case, the original capital investments are also the capital balances at the
beginning of the year since the partnership is only on its first year of operations. The profit of
P300,000 for 2019 is divided as follows:
Ratio of Capital Balances at the End of the Year. Assume that the profit is divided in the ratio
of capital balances at the end of the year before drawings and the distribution of profit. The
ending balances are P500,000 for Aguilar and P750,000 for Porras; the profit of P300,000 for
2019 is divided as follows:
Computation:
Aguilar: P300,000 x P500,000/1,250,000
Porras: P300,000 x P750,000/1,250,000
Ratio of Average Capital Balances. Division of profits or losses on the basis of the three
preceding capital concepts –original capital investments; capital balances at the beginning
of the year; or capital balances at the end of the year – may prove inequitable if there are
material changes in the capital accounts during the year.
When beginning capital balances are used in allocating profits, additional investments during
the year are discouraged because the partners making such investments are not
compensated in the division of profits until the next year.
If ending capital balances are used, year-end investments are encouraged, but there is no
incentive for a partner to make any investments before year end. In addition, amounts earlier
withdrawn may be reinvested before year-end. These considerations suggest that using
average balances as a basis for distributing profits or losses is preferable because it reflects
the capital actually available for use by the partnership during the year.
The agreement should also state the amount of drawings each partner may make. These
drawings are considered temporary and are recorded as debits to the partner’s drawing
account. Drawings within the allowable amount will not affect the computation of the
average capital balance. On the contrary, drawings in excess of the allowable amount are
considered permanent reductions in capital; hence, the computation of the average capital
balance is affected.
In the continuing illustration for the Aguilar and Porras Partnership, the partners are entitled to
withdraw P5,000 monthly or a total of P60,000 per annum. Any additional withdrawals are
directly debited to the partner’s capital accounts and therefore will affect the computation
of the average capital ratio.
Computation:
Aguilar: P300,000 x P475,000/1,250,000 P114,000
Porras: P300,000 x P775,000/1,250,000 186,000
In the preceding section, the plan for dividing the total profits in the ratio of partners’ capital
balances was based on the assumption that capital investments were the controlling fator in
the success of the partnership. However, it is not always the case. Consequently, partnerships
may choose to allocate a portion of the total profits in the capital ratio and the balance
equally or in other agreed ratio after due consideration of the partners’ other contributions.
To allow interest on partners’ capital account balances is almost similar to dividing part of
profits in the ratio of partners’ capital balances. If the partners agree to allow interest on
capital as a first step in the division of profit, they should specify the interest rate to be used.
it should also state whether interest is to be computed on capital balances on specific dates
or on average capital balances during the year.
Partners invested in a partnership for profits, not for interest. The interest on partners’ capital,
along with the other profit sharing plans to be discussed in the remainder of the chapter, are
to be considered as mere techniques to share partnerships profits of losses equitably and not
as expenses of the partnership. On the other hand, the interest on loans from partners is
recognized as expense and a factor in the measurement of profit or loss of the partnership.
Similarly, interest earned on loans to partners recognized as partnership income. This
treatment is consistent with the discussion in the previous chapter that loans receivable from
or payable to partners are assets and liabilities, respectively, of the partnership.
Continuing the illustration of Aguilar and Porras Partnership with a profit of P300,000 for 2019
and capital balances as already shown, assume that the partnership agreement allowed
15% interest on average capital account balances, with the balance to be divided equally.
The profit of P300,000 for 2019 is divided as follows:
Aguilar Porras Total
15% interest on average capital:
Aguilar: P475,000 x 15% P71,250
Porras : P775,000 x 15% P116,250
Sub total P187,500
Balance to be divided Equally
(P300,000-P187,500 = P112,500)
Aguilar: P112,500 x 50% 56,250
Porras: P112,500 x 50% 56,250 112,500
------------- -------------- --------------
Share of Partners in Profits P127,500 P172,500 P300,000
======= ======= =======
The Journal entry to close the income summary ledger account on December 31, 2019
follows:
Income summary 300,000
Lord Aguilar, drawing 127,500
Devzon Porras, drawing 172,500
To record the division of profits.
In a related case, assume that the Aguilar and Porras Partnership had a loss of P10,000 for the
year ended December 31, 2019. If the partnership agreement provided for interest on capital
accounts, this provision must be honored regardless of whether operations yielded profits or
not.
The loss will be shared by the partners in the same manner as the P300,000 profit. The total
interest allowance of P187,500 would still be given to the partners. The only difference is that
the division of profits or losses after the interest allowances would involve a larger negative
amount of P197,500 which will be divided equally between Aguilar and Porras.
The journal entry to close the income summary ledger account on December 31, 2019 follows:
Lord Aguilar, drawing 27,500
Income summary 10,000
Devzon Porras, drawing 17,500
After initial consideration, the idea that a loss of P10,000 should cause one partner’s capital
to increase and the other partner’s capital to decrease may appear unreasonable.
However, this result was planned and was with good reason. Partner Porras invested more
capital than Partner Aguilar; this capital was used to carry out operations, and the
partnership’s incurrence of a loss in the first year is no reason to disregard Porras’s larger
capital investment.
Comparison of distribution based solely on capital ratios as against distribution with interest
on capital balances. There will be a significant difference between the two distribution plans
if the partnership is operating at a loss. Under the capital ratio plan, the partner who invested
more capital will ultimately shoulder a bigger share of the loss. This result may be considered
inequitable because the investment of capital presumably is not the cause of the loss.
Under the interest plan, the partner who invested more capital is credited (increased) for an
interest on his capital and is ultimately debited (decreased) with a lesser share of the loss; in
some cases, the result may even be a net credit (increase).
The sharing agreement may provide for variations in compensating the personal services
contributed by partners. Even among partners who devote equal service time, one partner’s
superior experience and knowledge may command a greater share of the profit. To
acknowledge the harder working or more valuable partner, the profit-sharing plan may
provide for salary allowances.
The partnership agreement should be clear on the treatment of salary allowances when
losses are incurred. In the absence of an agreement to govern this situation, salary
allowances will be provided even when operations yielded losses. This allowance should not
be confused with salaries expense or with the partner’s drawing account which is debited for
periodic salary allowances. The cash withdrawals will in no way affect the division of profits;
the division of profits is governed by the sharing agreement.
Partners are the partnership’s owners; they are not employees of the business. If partners
devote their time and services to the affairs of the partnership, they are understood to do so
for profit, not for salary. Therefore, when the partners calculate the profit of the partnership,
salaries to the partners are not deducted as expenses in the statement of recognized income
and expense.
Continuing the illustration for the Aguilar and Porras Partnership, assume that the partnership
agreement provided for an annual salary of P100,000 to Aguilar and P60,000 to Porras, and
the balance to be divided equally. The profit of P300,000 for 2019 is divided as follows:
Aguilar Porras Total
Salary allowances P100,000 P60,000 P160,000
Balance to be divided equally
(P300,000 – P160,000 = P140,000):
Aguilar: P140,000 x 50% 70,000
Porras: P140,000 x 50% 70,000 140,000
Share of Partners in Profits P170,000 P130,000 P300,000
======= ======= ========
The journal entry to close the income summary ledger account on December 31, 2019 follows:
Income summary 300,000
Lord Aguilar, drawing 170,000
Devzon Porras, drawing 130,000
By Allowing Bonus to the Managing Partner Based on Profit and the Balance in an Agreed
Ratio
A partnership contract may provide for a special compensation in the form of bonus to the
managing partner when the results of operations of the partnerships are favorable. This
allowance is given in order to encourage the partner to maximize the profit potentials of the
partnership. Bonus is not being considered in the computation of profit, rather it is a mere
technique to distribute profits.
Assume that the Aguilar and Porras Partnership agreement provided for a bonus of 25% of
profit before bonus to Partner Aguilar and the balance to be divided equally. The profit is
P300,000.
Aguilar Porras Total
Bonus (25% x P300,000) P 75,000 P 75,000
Here, the P300,000 profit still includes the bonus. The difference between this profit and bonus
shall be the basis for the 25% bonus rate. Hence, profit after bonus represents 100% while the
profit of P300,000 before bonus represents 125%.
By Allowing Salaries, Interest on Capital, Bonus to managing Partner and the balance in an
Agreed Ratio
The service contributions and capital contributions of the partners are often not equal. If the
service contributions are not equal, salary allowances can compensate for the differences.
Or, when capital contributions are not equal, interest allowances can make up for the
unequal investments. When both service and capital contributions are unequal, the
allocation of profits or losses may include salary allowances, interest on their capital balances,
bonus to the managing partner, and the balance to be divided in an agreed ratio.
Note that the provisions for salaries and interest in the partnership agreement are called
allowances. These allowances are not reported in the statement of recognized income and
expense as salaries and interest expense; they are merely means of allocating profit to the
partners.
Assume that the profit for the year is P400,000 and the partnership agreement for the Aguilar
and Porras Partnership provided for the following:
1. Bonus to Aguilar of 25% of profit after salaries and interest but before bonus;
2. Annual salaries of P100,000 to Aguilar and P60,000 to Porras;
3. Interest on average capital balances of P71,250 and P116,250 to Aguilar and
Porras, respectively;
4. Balance to be divided in a ratio of 40:60.
Aguilar Porras Total
Salary Allowances P 100,000 P 60,00 0 P160,000
Interest on average capital balances 71,250 116,250 187,500
Bonus (25% P400,000-P100,000-P60,000
-P71,250-P116,250) 13,125 13,125
Balance to be divided in a ratio of 40:60
(P400,000-P160,000-P187,500-P13,125 =P39,375)
Journal entry to close the income summary ledger account on December 31, 2019 follows:
Income summary 400,000
Lord Aguilar, drawing 200,125
Devzon Porras, drawing 199,875
To record the division of profits
Assume instead that the bonus to Aguilar is 25% of profit after salaries, interest and after bonus.
The computation of the follows:
Profit before salaries, interest and bonus P400,000
Less: salaries P160,000
Interest 187,500 347,500
Profit after salaries and interest but before bonus P 52,500 125%
Profit after salaries, interest, and after bonus 42,000 100%
Bonus P 10,500 25%
======= ====
Aguilar Porras Total
Salary Allowance P100,000 P60,000 P160,000
The journal entry to close the income summary ledger account on December 31, 2019 follows:
Income summary 400,000
Lord Aguilar, drawing 198,550
Devzon Porras, drawing 201,450
Unfamiliar terms in the succeeding discussions which are partly based on IAS no. 1 (revised
2007) will be fully appreciated in higher accounting subjects. Suffice it to say, though, that at
this point you’re in a better situation than the users of other textbooks.
FINANCIAL REPORTING
Overall Considerations
Fair Presentation and Compliance with International Financial Reporting Standards (IFRSs).
The financial statements shall present fairly the financial position, financial performance and
cash flows of the entity. Fair presentation requires the faithful representation of the effects of
transactions, other events and conditions in accordance with the definitions and recognition
criteria for assets, liabilities, income and expenses set out in the IASB’s new Conceptual
Framework. Under IAS no. 1 (revised 2007), entities are required to make an explicit and
unreserved statement of compliance with IFRS in the notes.
Going Concern. Financial statements should be prepared on a going concern basis unless
management intends to liquidate the entity or cease trading or has no realistic option but to
do so.
Accrual Basis of Accounting. An entity shall prepare its financial statements, except for cash
flow information, using the accrual basis of accounting.
Materiality and Aggregation. An entity shall present separately each material class of similar
items. Material items that are dissimilar in nature or function should be separately disclosed.
Offsetting. An entity shall not offset assets and liabilities, income and expenses unless required
or permitted by an IFRS.
Consistency of Presentation. An entity shall retain the presentation and classification of items
in the financial statements in successive periods unless an alternative would be more
appropriate or an IFRS requires a change in presentation.
Identification of the Financial Statements. An entity shall clearly identify the financial
statements and distinguish them from other information in the same published document.
International financial Reporting Standard (IFRSs) apply only to the financial statements and
not necessarily to other information presented in an annual report, a regulatory filing or
another document.
An entity shall clearly identify each financial statement and the notes. An entity shall display
the following information prominently:
• Name of the reporting entity.
• Whether the financial statements are of the individual entity or a group of entities;
• The date of the end of the reporting period or the period covered by the set of
financial statements or notes;
• The presentation currency;
• And the level of rounding used in presenting amounts in the financial statements.
The form and content of the income statement of the partnership resemble those of the sole
proprietorship with the exception of the presentation of the division of profits or losses at the
lower portion of the statement.
Profit P300,000
========
Division of profit (equally):
Partner Aguilar P150,000
Partner Porras 150,000
Total P300,000
=======
The component of profits or loss may be presented either as part of a single statement of
comprehensive income or in an income statement, as permitted by paragraph 81 of IAS no.
1 (revised 2007). When an income statement is presented, it is part of a complete set of
financial statements and shall be displayed immediately before the statement of
comprehensive income.
As a minimum, the statement of financial performance shall include line items that present
the following amounts for the period:
a. Revenue;
b. Finance costs;
c. Share of profit or loss of associates and joint ventures accounted for using
the equity method;
d. Tax expense;
e. A single amount comprising the total of:
i. The post-tax profit or loss of discontinued operations; and
ii. The post-tax gain or loss recognized on the measurement to
fair value less costs to sell on the disposal of the assets or
disposal group(s) constituting the discontinued operations;
f. Profit or loss;
g. Each component of other financial performance classified by nature
(excluding amounts in (h) below);
h. Share of the other financial performance of associates and joint ventures
accounted for using the equity method; and
i. Total financial performance.
The components of equity referred to above include for example, each class of contributed
equity, the accumulated balance of each class of other comprehensive income and
retained earnings (these are applicable to corporations). The amount of dividends
recognized as distributions to owners during the period, and the related amount per share,
shall be presented either in the statement of changes in equity or in the notes.
In the case of Aguilar and Porras, as contrasted with a sole proprietorship, the number of
capital and drawing accounts has made the preparation of this statement all the more
useful. Changes in an entity’s equity between the beginning and the end of the reporting
period reflect the increase or decrease in its net assets during the period.
After all the components of the statement of financial performance along with the changes
in partners’ equity for the period have been properly presented, the preparation of the
statement of financial position will present no major difficulty. The assets and liabilities will be
presented in the statement of financial position as those of a sole proprietorship but the
owners’ equity section should exhibit separately the capital balance of P590,000 and
P840,000 for Aguilar and Porras, respectively.
Though some of the items are not as familiar yet, per revised international accounting
standards (IAS) no. 1 presentation of financial statements, as a minimum, the face of the
statement of financial position shall include line items that present the following amounts:
IAS no.1 (revised 2007) does not prescribe the order or format in which an entity presents
items. The above enumeration (from Paragraph 54 of IAS no.1 revised 2007) simply provides
a list of items that are sufficiently different in nature or function to warrant a separate
presentation in the statement of financial position.
Note that an entity makes the judgment about whether to present additional items
separately on the basis of an assessment of:
a. the nature and liquidity of assets;
b. the function of assets within the entity; and
c. the amounts, nature and timing of liabilities.
Current and noncurrent assets and liabilities should be separately classified on the face of
the statement of financial position except when a presentation based on liquidity provides
more reliable and relevant information.
An entity shall classified as asset as current when it satisfies any of the following criteria:
• it expects to realize the assets, intends to sell or consume it, in its normal operating
cycle; or
• it holds the asset primarily for the purpose of trading; or
• it expects to realize the asset within 12 months after the end of the reporting period;
or
• the asset is cash or a cash equivalent as defined in IAS no.7
All other assets are non-current. Operating cycle is the time between the acquisition of assets
for processing and their realization in cash or cash equivalents.
Ables and Galang divide partnership profits and losses solely on the basis of their
average capital balances. Ables had P275,000 invested during all of 2019; Galang
had P200,000 invested from January 1 to August 31, and he invested another P75,000
on September 1. If profit was P800,000 during 2019, how much should each partner
receive?
2. Abad, Aglugud, and Onate agreed to share profits and losses according to the ratio
of their respective investments at the beginning of the year of P300,000, P250,000, and
P450,000. Calculate the share of each partner under the following conditions: (a)
P270,000 profit; (b) 240,000 loss.
Learning Objectives:
DEFINITION
A corporation is an artificial being created by operation of law, having the right of succession
and the powers, attributes and properties expressly authorized by law or incident to its
existence (The Corporation Code of the Philippines, sec. 2)
ATTRUBUTES OF A CORPORATION
1. A corporation is an artificial being with a personally separate and apart from its
individual shareholders or members.
2. It is created by operation of law. It cannot come into existence by mere agreement
of the parties as in the case of business partnership. Corporations require special
authority or grant from the State, either by a special incorporation law that directly
creates the corporation or by means of a general corporation law (i.e.., the
corporation code of the Philippines).
3. It enjoy the right of succession. A corporation has the capacity of continued existence
subject to the period stated in the Articles of Incorporation. The death, withdrawal,
insolvency or incapacity of the individual shareholders or members will not dissolve the
corporation. The transfer of ownership of shares of stock does not dissolve the
corporation.
4. It has the powers, attributes and properties expressly authorized by law or incident to
its existence.
ADVANTAGES OF A CORPORATION
DISADVANTAGES OF A CORPORATION
CLASSES OF CORPORATIONS
1. Stock corporation. Corporations which have share capital divided into shares and are
authorized to distribute to the holders of such shares dividends or allotments of the
surplus profits on the basis of the shares held.
2. Non-stock corporation. A non-stock corporation is one where no part of its income is
distributable as dividends to its members, trustees or officers. Any profit that a non-
stock corporation may obtain as an incident to its operation shall, whenever
necessary or proper, be used for the furtherance of the purpose or purposes for which
the corporation was organized ( the Corporation Code of the Philippines, Sec. 87).
Non-stock corporations may be formed or organized for charitable, religious,
educational, professional, cultural, recreational, fraternal, literary, scientific, social,
civic service, or similar purposes (sec. 88).
There are three steps in the creation and organization of a corporation, namely:
1. Promotion. It is the process of bringing together the incorporators or the persons
interested in the business, of procuring subscriptions or capital for the corporation and
of setting in motion the machinery that leads to the incorporation of the corporation
itself.
2. Incorporation. This step includes the following:
a. Verification from the records of the Securities and Exchange Commission (SEC)
that the proposed corporate name is not the same or similar to an existing
corporation. The corporate name shall contain the word “Corporation” or
“Incorporated”, or the abbreviations “Corp.” or “Inc.,” respectively. The
corporate name of a foundation shall use the word “foundation”. A term that
describes the business of a corporation in its name should refer to its primary
purpose (SEC Memorandum Circular 5, Series of 2008).
b. Drafting and execution of the articles of incorporation (AI) by the
incorporators. The person elected as temporary treasurer should execute an
affidavit regarding the share capital subscribed and paid up. The treasurer
should also submit a sworn statement of assets and liabilities of the corporation.
c. Deposit by the treasurer of the cash paid for the shares subscribed in the bank
in the name of the treasurer in trust for and to the credit of the corporation.
The bank is required to issue a certificate of deposit.
d. Filling of the articles of incorporation with the SEC together with treasurer’s
affidavit, statement of financial position, certificate of bank deposit, and
certificate as to the name of the corporation;
e. Payment of the filling fees: for the AI, equivalent to 1/5 of 1% of the authorized
capital stock of the proposed corporation but not less than P1,000 for the by
laws, P510; for SEC form F-100, P2,000; and a legal research fee which is 1% of
the filling fee for the AI;
f. Endorsement from other government agencies if the proposed corporation will
engage in an industry regulated by the government, other requirements for
corporations with foreign equity and additional requirements based on the
kind of payment of subscriptions; and
g. Issuance by the SEC of the certificate of incorporation.
Section 22 of the Corporation Code states that if a corporation does not formally
organize and commence the transaction of its business within two (2) years from the
date of its incorporation, its corporate powers shall cease and the corporation shall
be deemed dissolved.
ARTICLES OF INCORPORATION
In the Philippines, the general law which governs the creation of private corporations is the
Corporation Code of the Philippines. Section 14 provides that all corporations organized
under this code shall file with the SEC articles of incorporation in any of the official languages
duly signed and acknowledged by all of the incorporators, containing substantially the
following matters except as otherwise prescribed by this Code or by special law:
9. If it be a non-stock corporation, the amount of its capital, the names, nationalities and
residences of the contributors and the amount contributed.
BY LAWS
These are the rules of action adopted by the corporation for its internal government and for
the government of its officers, shareholders or members. The by-laws shall be adopted within
one month from the issuance of the certificate of incorporation by the SEC. failure to file a
code of by-laws shall render the corporation liable for the revocation of its registration. A
private corporation may provide in its by-laws for:
1. The time, place and manner of calling and conducting regular or special meetings of
the directors;
2. The time and manner of calling and conducting regular or special meetings of the
shareholders or members.
3. The required quorum in meetings of shareholders or members and the manner of
voting there in;
4. The form for proxies of shareholders and members and manner of voting them;
5. The qualifications, duties and compensation of directors or trustees, officers and
employees.
6. The time for holding the annual election of directors or trustees and the mode or
manner of giving notice thereof;
7. The manner of election or appointment and the term of office of all officers other than
directors or trustees.
8. The penalties for violation of the by-laws.
9. In the case of stock corporations, the manner of issuing stock certificates; and
10. Such other matters as may be necessary for the proper or convenient transaction of
its corporate business and affairs.
RIGHTS OF A SHAREHOLDER
COMPONENTS OF A CORPORATION
1. Par value shares. One in which a specific amount is fixed in the articles of
incorporation and appearing on the certificate of stock. The par value is the minimum
issue price of the shares.
Section 6 of the code states that preference (or preferred) shares of stock may be
issued only as par value shares.
2. No-par value shares. One without any value appearing on the face of the certificate
of stock. A no-par value share may have a stated value which may be fixed in the
articles of incorporation or by the board of directors or the shareholders. Thus, the
issue price may vary from time to time as it is usually fixed based on the book value of
the corporation’s shares.
3. However, the minimum stated value of a no-par value share is five pesos (P5.00) per
share (section 6). In addition, shares issued without par value are deemed fully paid.
Banks, trust companies, insurance companies, public utilities, and building and loan
associations are not permitted to issue no-par value shares of stock.
At the time of incorporation, at least twenty – five (25%) percent of the authorized capital
stock (or share capital) as stated in the articles of incorporation must be subscribed and at
least twenty – five (25%) percent of the total subscription must be paid upon subscription, the
balance to be payable on a date or dates fixed in the contract of subscription without need
of a call, or in the absence of a fixed date or dates, upon call for payment by the board of
directors. In no case shall the paid-in capital be less than five thousand (P5,000) pesos. (the
Corporation Code of the Philippines, Sec. 13). In practice, the SEC requires higher minimum
capital requirements for particular types of corporations.
These requirements are mandatory. The SEC shall not accept the articles of incorporation of
any stock corporation unless accompanied by a sworn statement of the treasurer elected by
the subscribers showing that the minimum subscription and paid-in capital requirements have
been complied with. Observe that the new Corporation Code used the term “total”
subscription as the basis for the application of the second 25%. It is not necessary that each
and every subscriber shall pay twenty-five percent of his subscription. It is enough that 25%
of the total subscription is paid.
Illustration. Assume that the authorized share capital is P2,000,000 divided into 20,000 shares
with a par value of P100 per share. The subscribed share capital must be P500,000 which is
25% of the authorized share capital of P2,000,000. The paid-in capital should be P125,000
which is 25% of the subscribed share capital of P500,000.
Suppose that the authorized share capital is P60,000 divided into 6,000 P10 par value shares.
Applying the 25%-25% rule, the paid in capital will only amount to P3,750. The incorporators
must pay P5,000 because this is the minimum paid-in capital required by law.
In case of no-par value shares, the 25% requirement will be based on the authorized number
of shares. If the authorized capital is pegged at 2,000 no-par value shares, then at least 500
no-par value shares must be subscribed.
The ultimate control of the corporation rests with the shareholders. They are the owners of
the corporation. The shareholders elect the top governing body of the corporation, the
members of the board directors. The board of directors is responsible for the formulation of
the overall policies for the corporation and for the exercise of corporate powers. The board
also elects a chairman of the board.
The election of the professional management team or the administrative officers is entrusted
to the board. This team may include the president; executive vice- president; vice-presidents
in charge of sales, manufacturing, accounting, finance, administration and other key areas;
secretary; and controller. These officers implement the policies of the board of directors and
actively manage the day-to-day affairs of the corporation. Annually, a corporation holds the
shareholders’ meeting during which the shareholders elect their directors and make other
decisions.
Shareholders
Elect the
Board of Directors
Elect the
Officers
Hire
Employees
Sec. 25 of the Corporation Code of the Philippines, states that the president of a corporation
must be a director of the corporation, but he cannot act as president and secretary or as
president and treasurer at the same time. The president is the only officer required by law to
be a director.
The corporate secretary must be a resident and a citizen of the Philippines. He need not be
a director unless required by the corporate by-laws. It is generally the duty of the secretary
to make and keep its records and to make proper entries of the votes, resolutions and
proceedings of the shareholders and directors in the management of the corporation. The
corporate treasurer is the proper officer entrusted with the authority to receive and keep the
money of the corporation and to disburse them as he may be authorized. The treasurer may
or may not be a director.
There is no prohibition in the law against a shareholder being a director or officer of two or
more corporations. The Corporation Code does not prohibit a corporate officer from
occupying the same position in another corporation organized for the same purpose.
However, such situation may be prohibited by special law, the articles of incorporation or the
corporate by-laws. There is a particular case involving a business tycoon who wanted to
become a San Miguel Corporation director although he was already occupying the same
post in two corporations directly competing with the food and beverage giant. At that time,
San Miguel amended its by-laws to provide for the disqualification of a shareholder from
being a director of the corporation if the former already occupies the same position in a
competing firm. The Supreme Court later upheld the decision of San Miguel. Thus, a
corporation is authorized to prescribe qualifications for its directors (Gokongwei vs. sec, 89
SCRA 336).
Every private corporation, stock or non-stock, is required to keep books and records at its
principal office of the following.
1. Minutes book. It contains the minutes of the meetings of the directors and
shareholders.
2. Stock and transfer book. It is a record of the names of shareholders, installments paid
and unpaid by shareholders and dates of payment, any transfer of stock and dates
thereof, by whom and to whom made.
3. Books of accounts. These represent the record of all business transactions. The books
of accounts normally include the journal and the ledger.
4. Subscription book. It is a book of printed blank subscription.
5. Shareholders’ ledger. It is a ledger which details the number of shares issued to each
shareholders.
6. Subscribers’ ledger. It is a subsidiary ledger for the subscriptions receivable account;
it reports the individual subscriptions of the subscribers.
7. Stock certificate book. It is a book of printed blank certificate of stock.
Multiple Choice
Learning Objectives:
Shareholders’ Equity
Share Capital
SHARE CAPITAL
Legal Capital. Capital contributed by shareholders comes from the sale of shares of stock.
The shares of stock issued are generally referred to as share capital. Legal capital is that
portion of the contributed capital or the minimum amount of paid-in capital, which must
remain in the corporation for the protection of corporate creditors. The amount of legal
capital is determined as follows:
In case of par value shares, legal capital is the aggregate par value of all issued and
subscribed shares.
In case of no-par value shares, legal capital is the total consideration received by the
corporation for the issuance of its shares to the shareholders including the excess of issue price
over the stated value ( section 6, par. 3, Corporation Code of the Philippines).
Share Premium. ( or additional Paid-In Capital). It is the portion of the paid –in capital
representing amounts paid by shareholders in excess of par. It may also from transactions
involving treasury stocks, retirement of shares, donated capital, share dividends and any
other “gain” on the corporation’s own stock transactions.
Share capital is divided into transferable shares of stock. A share of stock represents the
interest or right of a shareholder in a corporation and is evidenced by a certificate of stock.
Share capital includes all types of ownership shares in a corporation. Shareholders acquire
either of the following basic types of share capital:
Ordinary Share. This share represents the basic ownership class of the corporation. When
only one class of share is issued, it must be ordinary share. Ordinary shares are the entity’s
residual equity.
Preference Share. This share gives its owners certain advantages over ordinary shareholders.
These special benefits relate either to the receipt of dividends when declared before the
ordinary shareholders (preferred as to dividends) or to priority claims on assets in the event of
corporate liquidation (preferred as to assets).
Authorized Share Capital. The number of authorized shares indicates the maximum number
of shares the corporation can issue as specified in the article of incorporation. This maximum
number of shares capital. Note that any increase or decrease in the authorized share capital
requires prior approval of the SEC and formal amendment to the articles of incorporation.
Issued Share Capital. These are shares which have been sold and paid for in full. Issued
share may include treasury shares. Share capital, either ordinary shares account or
preference shares account, is credited for the total par value of fully collected subscriptions
or in the case of no-par value shares, for the total consideration received in relation to the
issue. Share capital is debited only when the issued shares are retired, redeemed or
cancelled by the corporation.
Subscribed Share Capital. It is the portion of the authorized share capital that has been
subscribed but not fully paid. This shareholders’ equity account is credited for the total par
value of the shares subscribed and debited for the total par value of the collected
subscriptions.
Outstanding Share Capital. These are issued shares, which are in the hands of the
shareholders. The number of outstanding shares will equal the difference the issued shares
and the treasury shares.
Treasury Stock. These are issued shares acquired by the corporation but not retired and are
therefore, waiting to be reissued at a later date.
The entry to record the issuance of share capital depends on whether the stock is with or
without par value.
When shares with par value are sold, the proceeds should be credited to the share
capital account to the extent of the par value of the shares, with any excess being
reflected as share premium.
When shares without par value are sold, the proceeds should be credited to the share
capital account. If the no-par stock has a stated value, the excess proceeds over
stated value may alternatively be credited to share premium.
Section 65 of the Corporation Code prohibits the original issue of share capital (or capital
stock) for a consideration less than the par or stated value (i.e. issued at a discount).
Corporation set the par value of their ordinary shares at nominal amounts such as P1 per
share. The par value is no indication of its market value; it merely indicates the amount per
share to be entered in the share capital account.
Share capital may be issued in exchange for any of the following considerations:
1. Actual cash paid to the corporation.
2. Tangible or intangible properties actually received by the corporation.
3. Labor already performed for or services actually rendered to the corporation.
4. Previously incurred indebtedness by the corporation.
In issuing its share capital, a corporation may avail of the services of an investment banker
who is specialist in marketing shares to investors. The investment banker may underwrite a
share issue which means that the banker agrees to buy the shares of the corporation and to
sell them to investors. The corporation considers the shares as sold because the underwriter
will buy the shares that he is not able to sell. The underwriter bears this risk in return for gains
from selling the shares at a price higher than that paid to the corporation. An investment
banker who is not willing to underwrite may handle a share issue on a best efforts basis. In this
case, the banker undertakes to sell as many shares as possible at a set price but the
corporation bears the risk on unsold shares.
Share issue costs can be quite substantial given the work involved. The costs include costs
associated with preparing, printing and filling the relevant documentation and marketing the
share issue. Various experts are consulted to ensure a successful issue.
An entity typically incurs various costs in issuing or acquiring its own equity instruments.
Those costs might include registration and other regulatory fees, amounts paid to
legal, accounting and other professional advisers, printing costs and stamp duties. The
transaction costs of an equity transaction are accounted for as a deduction from
equity (net of any related income tax benefit) to the extent they are incremental costs
directly attributable to the equity transaction that otherwise would have been
avoided. The costs of an equity transaction that is abandoned are recognized as an
expense.
Per Philippine Interpretations Committee (PIC), the costs of listing shares in the stock market
are not considered as costs of an “equity transaction” since no equity instrument has been
issued and, hence, such costs are recognized as an expense in profit or loss when incurred.
They are as follows: road show presentation, public relations consultation’s fees, and stock
exchange listing fees.
Per IAS 32, paragraph 38, transaction costs that relate jointly to more than one transaction
(for example, costs of a concurrent offering of some shares and a stock exchange listing of
other shares) should be allocated on a rational and consistent basis. Examples of joint costs
are as follows: Audit and other professional advice relating to prospectus, opinion of counsel,
tax opinion, fairness opinion and valuation report, and prospectus design and printing.
Most share issues are for cash since the primary reason for issuing shares is to raise capital for
a corporation’s operating activities. The entries to record the issuance of shares for cash will
depend on whether the share is with or without par value.
Illustration. Narsan Holdings is authorized to issue P1,000,000 ordinary shares dividend into
10,000 shares, with a par value of P100 per share. The diversified corporation issued on cash
basis 2,000 shares at par. The share issuance entry will be:
Cash 200,000
Ordinary shares 200,000
The amount of P200,000 invested in the corporation is called paid-in capital or contributed
capital. The credit to Ordinary shares increases the share capital of the corporation.
Illustration. Suppose the 2,000 shares were sold at P150 per share, the entry follows:
Cash 300,000
Ordinary shares 200,000
Share premium 100,000
This sale of shares increases the corporation’s contributed capital by P300,000. When the
shares with par value are sold, the proceeds should be credited to the ordinary shares
account to the extent of the par value – in this case, P200,000; with any excess to be reflected
in the share premium account. The excess of P100,000 is not a “gain”. The corporation can
neither earn a profit nor incur a loss when it issues shares to or acquires shares from its
shareholders.
Illustration. Suppose that Morning Star travel’s no-par ordinary shares have a stated value of
P20. The entity issued 5,000 shares at P25 per share. The entry will be:
Cash 125,000
Ordinary shares 125,000
When shares without par value are sold, the proceeds should be credited to the ordinary
shares account. If the no-par stock has a stated value, the excess proceeds over stated
value – in this case, P5 per share, may alternatively be credited to share premium.
Cash 125,000
Ordinary shares 100,000
Share Premium 25,000
SUBSCRIPTION OF SHARES
There are times when a corporation sells its shares directly to investors on a subscription basis.
The subscription contract is a legally binding contract which provides for the number of shares
subscribed, the subscription price, the terms of payment and other conditions of the
transaction. A subscriber becomes a shareholder upon subscription but the stock certificates
evidencing ownership over shares of stocks are not issued until the full collection of the
subscription.
Illustration. Warranty Auto Shop, Inc. is a quality car care center located at St. Paul St., San
Antonio Village, Makati City. Assume that 5,000 shares of P10 par value ordinary shares of
the corporation were sold on subscription at P12 per share on Sept. 1, 2019 to Ashley Langga.
Subscription installments of P24,000 and P36,000 will be due on Sept. 16 and 30, respectively.
Cash 24,000
Subscriptions Receivable 24,000
To record initial installment
Cash 36,000
Subscriptions Receivable 36,000
To record final installment.
There are instances when a subscriber fails to settle the subscriptions in full on the date
specified in the subscription contract or in the “call” made by the board of directors. In such
case, the subscribed shares are declared delinquent shares. The usual remedy is to dispose
of these shares in a public auction for the account of the delinquent subscriber. These shares
will be sold to the person who is willing to pay the “offer price” which includes the full amount
of the subscription balance plus accrued interest, cost of advertisement and expenses of
auction sale in exchange for the smallest number of shares. This person is referred to as the
highest bidder.
Illustration. Assuming the same facts as above except that the subscriber failed to settle part
of his subscriptions in the amount of P48,000. After complying with the legal procedures
pertaining to delinquency sale, a public auction was held. The offer price is P56,000 including
P3,000 accrued interest and P5,000 expenses of sale. Three bidders are willing to pay the offer
price, namely:
Loqueloque is the highest bidder. The 5,000 shares are deemed fully paid. Ashley Lagga, the
original subscriber, gets 700 shares and Loqueloque receives 4,300 shares.
Cash 12,000
Subscriptions Receivable 12,000
To record partial initial installment.
Cash 56,000
Receivable from highest bidder 8,000
Subscriptions Receivable 48,000
To record sale at public auction.
TREASURY STOCKS
Treasury stocks are shares of stock which have been issued and fully paid for, but
subsequently reacquired by the issuing corporation either by purchase, redemption,
donation or through other lawful means. Such shares may again be disposed of for a
reasonable price fixed by the board of directors.
Section 41 of Corporation Code provides that a stock corporation has the power to purchase
its own shares for a legitimate purpose it has unrestricted retained earnings. Some of the
reasons for the purchase of treasury stock are as follows: (1) to support employee stock
compensation plans; (2) to improve the stock market price by decreasing the supply of
shares; (3) to avoid takeover by an outside party.
Treasury stock is not an asset because the corporation may not own shares itself. To reiterate,
it is reported as a deduction from the total shareholders’ equity. There are two methods of
accounting for treasury stock transactions, namely: (1) par or stated value method and (2)
cost method. In the first method, treasury stock is debited for an amount equal to the par or
stated value of the stock reacquired. The cost method is the preferred method of accounting
for treasury stocks by the accounting standard council as stated in SFAS no. 18, par. 6. Only
the cost method will be illustrated.
When the cost method is used, treasury stock is recorded at cost regardless of whether the
share is acquired below or above par or stated value. If treasury stock is purchased for cash,
the cost is equal to the cash payment. If the treasury stock is acquired for non-cash assets
consideration, the cost is usually measured by the recorded amount of the non-cash assets
surrendered or given in exchange.
The purchase of treasury shares does not decrease the number of shares issued; only the
outstanding shares decrease. The effect of the purchase is to decrease both total assets and
total shareholders’ equity. Treasury stock transactions may affect cash flows but they have
no effect on the profit of the corporation.
Illustration. Plantation EcoResort is world class destination in Indang, Cavite. The operations
have been successful. To consolidate control over the enterprise and thus avoid a corporate
takeover by outsiders, the board of directors decided to minimize outstanding shares by
purchasing 1,500 shares with a par value of 1,000 for P2,000.
The entry will be:
Treasury stock 3,000,000
Cash 3,000,000
To record acquisition of treasury shares.
At cost. Assume that the treasury shares were subsequently reissued at cost.
Cash 3,000,000
Treasury stock 3,000,000
To record reissue of treasury shares at cost.
Above cost. Assume that all treasury shares were reissued at P2,500 per share.
Cash 3,750,000
Treasury stock 3,000,000
Share premium-treasury 750,000
To record reissue of treasury shares above cost.
Treasury stock is always debited for the cost of the shares purchased or credited for the cost
of the shares reissued. There is no reference to par value. The excess over cost of P750,000 is
not regarded as a “gain” but as a component of share premium.
Below Cost. Assume that the 1,500 treasury shares were reissued at P1,500 per share.
Cash 2,250,000
Retained earnings 750,000
Treasury stock 3,000,000
To record reissue of treasury shares below cost.
The excess of the cost over reissue price of P750,000 should be debited to share premium –
treasury to the extent of its balance. In the absence of any balance in this account, the “loss”
is debited to retained earnings. It is assumed in the above illustration that the share premium-
treasury has a zero balance.
The shares purchased may be subsequently retired. The ordinary shares account is reduced
by its par value. The number of shares issued is reduced by the stock retired. The treasury
stock account is credited at cost. Retirement may result in a “gain” or “loss” (note IAS 32, par.
33).
With Gain on Retirement. Assume that Plantation EcoResort purchased the treasury shares for
P750 per share. Observe that there is a “gain” on retirement if the cost of treasury shares is
less than par value.
Ordinary shares (1,500 shs. X P1,000 par) 1,500,000
Share premium 375,000
Treasury stock (1,500shs. X P750 cost) 1,125,000
To record retirement of treasury shares.
With loss on Retirement. Assume that a total of 10,000 shares have been issued at P1,500 per
share prior to the purchase of treasury shares. Plantation EcoResort purchased 1,500 treasury
shares for P2,000 per share; these were not reissued and were ultimately retired.
The “loss” on retirement of P1,500,000 should be debited to the following accounts in the order
given:
(1) share premium to the extent of the credit when the share is issued;
(2) share premium from treasury stock transactions of the same class of
share;
(3) retained earnings
In relation to the illustration above, the credit to share premium applicable to the 1,500 shares
when originally issued was P750,000 (P1,500 issue-P1,000 par) x 1,500 shares. Hence, when the
shares are retired the debit to share premium is only to the extent of P750,000. The first priority
was satisfied after taking special notice of the of the limitation. There is no share premium –
treasury so the balance of P750,000 was debited to retained earnings.
Illustration. The accounts below appeared in the trial balance of Jocelyn Cruz events
Management Corporation as at December 31, 2019:
At this point, it is useful to summarize the effects of the basic shareholders’ equity transactions
on the elements of the statement of financial position:
Retained earnings represent the component of the shareholders’ equity arising from the
retention of assets generated from the profit-directed activities of the corporation. At the
end of an accounting period, the income summary account of a corporation is closed to the
retained earnings account. The retained earnings account is credited with the corporation’s
profit or debited with the loss. The basic source of retained earnings is profit. Distributions to
shareholders of cash, property or stocks from unrestricted retained earnings on the basis of all
issued and fully paid shares, and all subscribed par value shares except treasury shares are
called dividends. Dividend declarations reduce retained earnings.
Other less common situations that cause increases or decreases in retained earnings are as
follows: debits resulting from reissuance of treasury stocks below cost and loss on retirement
of treasury stocks; and debits or credits for prior period errors.
Prior period errors are errors discovered in the current period that are of such significance that
the financial statements of one or more prior periods can no longer be considered to have
been reliable at the date of their issue. Note that credit entries increase the retained earnings
balance and debits decrease it.
A debit balance in the Retained Earnings may be restricted or appropriated, and unrestricted
or unappropriated. Unrestricted retained earnings are free and can be declared as
dividends. Retained earnings restrictions may be legal, contractual or voluntary.
DIVIDENDS in GENERAL
Dividends may take the form of cash, property or additional shares of stock of the
corporation. As a general rule, any form of dividend declaration should be based on the
total subscription of a shareholder and not merely on the shares already paid. Subscribers
are considered shareholders from the time their subscriptions are accepted by the
corporation and not from the time they are issued stock certificates.
The declaration and payment of dividends involve three important dates and they are:
Date of Declaration
On the date of declaration, the board of directors will adopt a resolution declaring that a
dividends is to be paid. The resolution will specify the amount, type and date of payment of
this dividend. It will also set a date of record. Cash dividends are declared solely by the
board of directors while share dividends will necessitate the concurrence at least two-thirds
of the outstanding shareholders.
Legally, declared dividends are obligations of the firm. Dividends to be paid in cash or
property become a liability on this dates. Shares distributable is also recognized. An entry is
made debiting retained earnings and crediting a dividend liability or shares distributable
account. Some corporations debit a dividends declared account instead of the retained
earnings account. This account is nevertheless closed to the retained earnings account at
the end of the year.
Paragraph 10 of IFRIC 17 provides that the liability to pay a dividend shall be recognized when
the dividend is appropriately authorized and is no longer at the discretion of the entity, which
is the date:
(a) when declaration of the dividend, e.g. by management or the board of
directors, is approved by the relevant authority, e. g. the shareholders, if the
jurisdiction requires such approval, or
(b) when the dividend is declared, e.g. by management or the board of
directors, if the jurisdiction does not require further approval
IFRIC 17 Distributions of Non- cash assets to owners was developed by the International
Financial Reporting Interpretation Committee and issued by the International Standards
Board in November 2008. Its effectivity date is July 1 2009.
Date of Record
A list of shareholders entitled to the declared dividends is prepared at the date of record. If
an investor buys a share of stock after this date, he will not receive the dividend. The share is
said to be traded ex-dividend. No entry is required on this date.
Date of Payment
The corporation settles its liability on this date. An entry is made debiting the dividend liability
or shares distributable account and crediting cash, property distributed or share capital.
CASH DIVIDENDS
A corporation, however, may successfully accumulate earnings and at the same time not be
sufficiently liquid to pay large dividends. Many corporations, especially new firms in growth
industries, finance their expansion from assets generated through earnings and pay out small
cash dividends or non at all.
Dividends on par value shares are stated as a certain percentage of the par value. As to no-
par value shares, the dividends are stated at a certain amount per share. When the board of
directors declares a cash dividend, an entry is made debiting retained earnings and crediting
cash dividends payable.
Illustration. Made Easy Bookstore, Inc., a nationally-known business books distribution entity,
declared a cash dividend of P12 per share of ordinary shares on July 1. The dividends are
payable on August 1 to shareholders of record on July 21. The entity has 100,000 ordinary
shares issued of which 7,000 shares are held in treasury. The entries to record the dividend
declaration and payment are as follows:
The account, cash dividend declared, may be used in place of the debit to retained
earnings. At the end of the accounting period, this temporary shareholders’ equity account
will be closed by debiting retained earnings and crediting cash dividends declared.
Cash dividends payable are reported as current liabilities in the statement of financial
position. Note that cash dividends decrease total assets and total shareholders’ equity.
It is worthwhile to reiterate that with the exception of treasury shares, all issued and fully paid
shares, and all subscribed par value shares are entitled to dividends when declared. The
subscribed shares must be par value shares. No-par value shares are considered as legally
issued only when fully paid. Unissued shares, subscribed no-par value shares and treasury
shares are not entitled to dividends.
SHARE DIVIDENDS
A corporation may distribute to shareholders additional shares of the entity’s own share as
share dividends. Share dividends or bonus issues are fundamentally different from cash or
property dividends because share dividends do not transfer assets to the shareholders. This
type of dividend affects only the accounts within the shareholders’ equity. Share dividends
increase the total share capital and decrease the retained earnings account. Because both
of these are components of shareholders’ equity, total shareholders’ equity in unchanged.
From the shareholders’ point of view, a share dividend does not change their percentage
interest in the corporation although total outstanding shares have increased. The accounting
entries depend upon the size of the share dividend.
Small share dividends are dividends in which the additional shares issued are less than 20% of
the previously outstanding shares. These share dividends are recorded by transferring from
retained earnings to share capital (ordinary shares and share premium accounts) the fair
market value of the additional shares to be issued. In cases when the fair market value is
lower than the par or stated value, the par or stated value will be the basis for recording.
Illustration. Siobel Your Japanese Fastfood, Inc., chain is blessed with years of profitable
operations for its commitment to serve affordable and healthy Japanese food favorites. The
shareholders’ equity before declaration of a 10% share dividend is as follows:
The declaration of a 10% share dividend will require the issuance of an additional 2,000 shares.
Assume that the corporation’s share is being traded at the stock exchange and that the stock
market price per share is P110. The fair market value of the shares to be distributed is P220,000.
The entries will be:
Retained Earnings (or the temporary account, share dividends declared) is debited for the
fair market value of the share dividends. Shares distributable is credited for the par value of
the shares to be distributed and share premium for the balance.
If a statement of financial position is prepared between the declaration date and the
distribution date of a share dividend, the shares distributable account will be shown in the
shareholders’ equity immediately after the ordinary shares account.
When the share is distributed, only the components of the shareholders’ equity changes;
retained earnings decreased by P220,000 (P650,000 minus P430,000) and total share capital
increased by P220,000 (P1,420,000 minus P1,200,000). The total shareholders’ equity did not
change.
A comparison of the shareholders’ equity and outstanding shares before and after the share
dividend appears below:
The receipt of a share dividend does not alter the relative position of a shareholder. If a 10%
share dividend is distributed, all shareholders increase their proportionate holdings by 10%,
and the total share outstanding is increased by the same proportion. No profit is realized by
the shareholders.
If the share dividend is 20% or more of the previously outstanding shares such that the effect
is to reduce materially the market value per share, then only the par or stated value is
credited to ordinary shares with a corresponding debit to retained earnings.
Illustration. Assume instead that Siobel Your Japanese Fastfood, Inc., chain declared a 20%
share dividend on its 20,000 issued and outstanding P50 par value shares. The corporation
will issue additional 4,000 shares due to the share dividend. The entries will be:
The account titles used to record a large share dividend are the same as those for small share
dividends. Note though that the balance in the account – share premium remained the
same; this is because large share dividends are recorded at par value.
Before After Increase
Dividends dividends (decrease)
Ordinary shares, P50 par, 20,000
Shares issued and outstanding P1,000,000 P1,200,000 P200,000
Share Premium 200,000 200,000 -
Total Share Capital P1,200,000 P1,400,000 P200,000
Retained Earnings 650,000 450,000 (200,000)
Total Shareholders’ Equity P1,850,000 P1,850,000 -
========= ========= =======
Shares Issued and Outstanding 20,000 24,000 4,000
====== ====== ======
This statement is not required per revised International Accounting Standard (IAS) no. 1. The
required financial statements were enumerated in an earlier chapter. A retained earnings
statement is normally divided into two major sections:
• Appropriated. This section presents the beginning balance of the retained earnings
appropriated account, any additions or deductions during the period, and ending
balance.
• Unappropriated. This section shows the beginning balance of the retained earnings
unappropriated account, correction of prior period error, profit or loss for the period,
dividends, transfers to and from the appropriated and unappropriated accounts, and
the ending balance.
The statement concludes with the total retained earnings as of the end of the period. An
example of a retained earnings statement follows:
Unappropriated:
Balance, 1/1/2019, as previously reported P1,414,500
Correction of prior period error 100,000
Balance, 1/1 2019, as restated P1,514,500
Add: Profit 480,000
Total P1,994,500
Less: Cash dividend declared P 65,000
Share dividend declared 60,000
Transfer to appro. For treasury 100,000 225,000
Retained Earnings Unappropriated, 12/31/ 2019 1,769,500
Total Retained Earnings P2,049,500
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Multiple choice: