Chapter 1 contribute money, property, or industry
Definition of Accounting
Accounting is a service activity. Its
function is to provide quantitative
information, primarily financial in nature,
about economic entities that is intended to be
useful in making economic decisions.
Accounting is an information system that
measures, processes and communicates
financial information about economic entity.
Accounting is the process of identifying,
measuring and communicating economic
information to permit informed judgments
and decisions by users of the information.
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
1. 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.
2. Trading – An entities or individual that
buys and sells the products (buying and
selling). Examples are supermarket,
department store and others.
3. Manufacturing – An entities that
convert materials into finished products.
Examples are furniture’s production,
noodles production, shoes
manufacturing, garment factories and
food processing.
Forms of Business Organization
1. Sole proprietorship. This business
organization has a single owner called the
proprietor who generally is also the
manager. Sole proprietorships tend to be
small service type (e.g., physicians,
lawyers, and accountants) businesses and
retail establishments. The owner receives
all profits, absorbs all losses and is solely
responsible for all debts of the business.
2. Partnership. A partnership is a
business owned and operated by two or
more persons who bind themselves to
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.
3. Corporation. A corporation is a
business owned by its stockholders. It is
an artificial being created by operation of
law, having the rights of succession and
the powers, attributes and properties
expressly authorized by law or incident to
its existence. The stockholders are not
personally liable for the corporation’s
debts.
Fundamental Concepts
Several fundamental concepts
underlie the accounting process. In recording
business transactions, accountants should
consider the following:
1. 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.
2. 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.
3. 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.
4. 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.
Elements of Financial Statements
The elements of financial statements defined
in the March 2018 Conceptual Framework for
financial reporting (2018 Conceptual
Framework) are:
• Assets, liabilities and equity – relate
to a reporting entity’s financial
position; and
• Income and expenses – relate to a
reporting entity’s financial
performance.
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”.
A liability is a present obligation of the entity
to transfer an economic resource as a result of
past events. For a liability to exists, three
criteria must all be satisfied.
a. the entity has an obligation;
b. the obligation is to transfer an economic
resource; and
c. the obligation is a present obligation that
exists as a result of past events.
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.
A present obligation exists as a result of past
events only if:
a. the entity already obtained economic
benefits or taken an action; and
b. as a consequence, the entity will or
may have to transfer an economic
resource that it would not otherwise
have had to transfer.
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.
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 The account type determines how
increases or decreases in it are recorded.
Debit Credit Increases in assets are recorded as debits
while decreases in assets are recorded as
side side credits. Conversely, increases in liabilities
Left and owner’s equity are recorded by credits
side Right
and decreases are entered as debits.
Side
The rules of debit and credit for
income and expense accounts are based on
The Accounting Equation
the relationship of these accounts to owner’s
Financial statements tell us how a
equity. Income increases owner’s and
business is performing. They are the final
expense decreases owner’s equity. Hence,
products of the accounting process. But how
increases in income are recorded as credits
do we arrive at the items and amounts that
and decreases as debits. Increases in
make up the financial statements? The most
expenses are recorded as debits and decreases
basic tool of accounting is the accounting
as credit. These are the rules of debit and
equation. This equation presents the
credit. The following summarizes the rules
resources controlled by the enterprise, the
present obligations of the enterprise and the
residual interest in the assets. It states that Normal Balance of an Account
assets must always equal liabilities and The normal balance of any account
owner’s equity. The basic accounting model refers to the side of the account- debit or
is: credit-where increases are recorded. Assets
owner’s withdrawal and expense accounts
normally have debit balances; liability,
Assets = Liabilities + Owner’s Equity
owner’s equity and income accounts normally
have credit balances. This result occurs
Note that the assets are on the left
because increases in an account are usually
side of the equation opposite the liabilities
greater than or equal to decreases.
and owner’s equity. This explains why
increases and decreases in assets are recorded Incre Reco Nor Bala
in the opposite manner (“mirror image”) as ases ded mal nce
liabilities and owner’s equity are recorded. by
The equation also explains why liabilities and Account Debit Credi Debi Cred
owner’s equity follow the same rules of debit t t it
and credit.
Assets X X
Debits and Credits – the double-entry liabilitie X X
bookkeeping system s
Owner’s
Accounting is based on a double –
equity
entry bookkeeping system which means that
the dual effects of a business transaction is Owner’s X X
recorded. A debit side entry must have a capital
corresponding credit side entry. For every Withdra X X
transaction, there must be one or more wals
accounts debited and one or more accounts
credited. Each transaction affects at least two Income X X
accounts. The total debits for a transaction expense X X
must always equal the total credits. s

An account is debited when an Accounting Events and Transactions

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.
An accounting event is an economic
occurrence that causes changes in an
enterprise’s assets, liabilities, and/or equity.
Events may be internal actions, such as the
use of equipment for the production of goods
 or services. It can also be an external event,
such as the purchase of raw materials from a
supplier. A transaction is a particular kind of
event that involves the transfer of something
of value between two entities. Examples of
transactions include acquiring assets from
owner, borrowing funds from creditors, and
purchasing or selling goods and services.
Types and Effects of Transactions
It will be beneficial in the long-term
to be able to understand a classification
approach that emphasizes the effects of
accounting events rather the recording
procedures involved. This approach is quite
pioneering. Although business entities
engage in numerous transactions, all
transactions can be classified into one of four
types, namely:
1. Source of Assets (SA). An asset account
increases and a corresponding claims
(liabilities or owner’s equity) accounts
increases. Examples: (1) Purchase of supplies
on account; (2) sold goods on cash on delivery
basis.
2. Exchange of Assets (EA). One asset
account increases and another asset account
decreases. Example: acquired equipment for
cash.
3. Use of assets (UA). An asset account
decreases and a corresponding claims
(liabilities or equity) account decreases.
Example: (1) Settled accounts payable; (2)
paid salaries of employees.
4. Exchange of claims (EC). One claims
(liabilities or owner’s equity) account
increases and another claims (liabilities or
owner’s equity) account decreases. Example:
received utilities bill but did not pay.
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)
Statement of Financial Position
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
1. 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.
2. 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.
3. 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.
4. 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.
5. 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.
6. 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.
Non –current assets
1. 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.
2. 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.
3. 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.
All other liabilities should be classified as non-
current liabilities.
Current Liabilities
1. 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.
2. 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.
3. Accrued Liabilities. Amounts owed to
others for unpaid expenses. This account
includes salaries payable, utilities
payable, interest payable and taxes
payable.
4. 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.
5. 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.
 Non –current liabilities
1. 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.
2. 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
1. 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.
2. 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.
3. 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
1. Service Income. Revenues earned by
performing services for a customer or
client; for example, accounting services
by a CPA firm, laundry shop.
2. Sales. Revenues earned as a result of
sale of merchandise; for example, sale of
building materials by a construction
supplies firm.
Expenses
1. 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.
2. Salaries or wages expense. Includes
all payments as a result of an employer-
employee relationship such as salaries or
wages, 13th month pay, cost of living
allowances and other related benefits.
3. Telecommunications, electricity,
fuel and water expenses. Expenses
related to use of telecommunications
facilities, consumption of electricity, fuel
and water.
4. Rent expense. Expense for space,
equipment or other asset rentals.
5. Supplies expense. Expense of using
supplies (e.g. office supplies) in the
conduct of daily business.
6. Insurance expense. Portion of
premiums paid on insurance coverage
(e.g. on motor vehicle, health, life, fire,
typhoon or flood) which has expired.
7. 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.
8. Uncollectible account expense. The
amount of receivables estimated to be
doubtful of collection and charged as
expense during an accounting period.
9. Interest expense. An expense related
to use of borrowed funds.
Accounting for Business Transactions
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.
 Financial Transaction Worksheet
Every financial transaction can be
analyzed or expressed in terms of its effects
on the accounting equation. The financial
transactions will be analyzed by means of a
financial transaction worksheet which is a
form used to analyze increases and decreases
in the assets, liabilities or owner’s equity of a
business entity.
Chapter 2:
Recording Business Transactions
Transaction Analysis (Step 1)
The analysis of transactions should follow
these four basic steps:
1. Identify the transaction from source
documents.
2. Indicate the accounts – either assets,
liabilities, equity, income or expenses –
affected by the transaction.
3. Ascertain whether each account is increased
or decreased by the transaction.
4. Using the rules of debit and credit, determine
whether to debit or credit the account to
record its increase or decrease.
Source Documents
Transactions and events are the
starting points in the accounting cycle. 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
The accounting cycle refers to a series
of sequential steps or procedures performed
to accomplish the accounting process. The
steps in the cycle and their aims follow:
Step 1: Identification of Events to be
recorded
Aim: To gather information about
transactions or events generally through the
source documents.
Step 2: Transactions are recorded in
the Journal
Aim: To record the economic impact of
transactions on the firm in a journal, which is
a form that facilitates transfer to the accounts.
Step 3: Journal Entries are posted to
the ledger
Aim: To transfer the information from the
journal to the ledger for classification.
Step 4: Preparation of the trial balance
Aim: To provide a listing to verify the equality
of debits and credits in the ledger.
Step 5: Preparation of the worksheet
including adjusting entries
Aim: To aid in the preparation of financial
statements.
Step 6: Preparation of financial
statements
Aim: To provide useful information to
decision –makers.
Step 7: Adjusting journal entries are
journalized and posted
Aim: To record the accruals, expiration of
deferrals, estimations and other events from
the worksheet.
Step 8: Closing Journal entries are
journalized and posted
Aim: To close temporary accounts and
transfer profit to owner’s equity.
Step 9: Preparation of a post-closing
trial balance
Aim: To check the equality of debits and after
the closing entries.
Step 10: Reversing journal entries are
journalized and posted
Aim: To simplify the recording of certain
regular transactions in the next accounting
period.
This cycle is repeated each accounting
period. 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.
Simple and Compound Entry
In a simple entry, only two accounts
are affected – one account is debited and the
other account credited. An example of this is
the entry to record the initial investment of
PerezManalo. However, some transactions
require the use of more than two accounts.
When three or more accounts are required in
a journal entry, the entry is referred to as a
compound entry.
Transactions are journalized (Step 2)
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.
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.
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.
Ledger accounts after posting
At the end of an accounting period, the
debit or credit balance of each account must
be determined to enable us to come up with a
trial balance.
• Each account balance is determined
by footing (adding) all the debits and
credits.
• If the sum of an account’s debits is
greater than the sum of its credits,
that account has a debit balance.
• If the sum of its credits is greater, that
account has a credit balance.
Trial Balance (Step 4)
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 procedures in the preparation of a trial
balance follow:
1. List the account titles in numerical order.
2. Obtain the account balance of each account
from the ledger and enter the debit balances
in the debit column and the credit balances in
the credit column.
3. Add the debit and credit columns.
4. Compare the totals.
The trial balance is a control device
that helps minimize accounting errors. When
the totals are equal, the trial balance is in
balance. This equality provides an interim
proof of the accuracy of the records but it does
not signify the absence of errors. For example,
if the bookkeeper failed to record payment of
rent, the trial balance columns are equal but
in reality, the accounts are incorrect since rent
expense is understated and cash overstated.
Locating Errors
An inequality in the totals of the debits
and credits would automatically signal the
presence of an error. These errors include:
1. Error in posting a transaction to the ledger:
a. An erroneous amount was posted to
the account.
b. A debit entry was posted as a credit or
vice versa.
c. A debit or credit posting was omitted.
2. Error in determining the account balances:
a. A balance was incorrectly computed
b. A balance was entered in the wrong
balance column.
3. Error in preparing the trial balance:
a. One of the columns of the trial
balance was incorrectly added.
b. The amount of an account balance
was incorrectly recorded on the trial
balance.
c. A debit balance was recorded on the
trial balance as a credit or vice versa,
or a balance was omitted entirely.
What is the most efficient approach in
locating an error? The following procedures
when done in sequence may save considerable
time and effort in locating errors:
1. Prove the addition of the trial balance
columns by adding these columns in the
opposite direction.
2. If the error does not lie in addition,
determine the exact amount by which the
trial balance is out of balance. The amount
of the discrepancy is often a clue to the
 source of the error. If the discrepancy is
divisible by 9, this suggests either a
transposition (reversing the order of
numbers) error or a slide (moving of the
decimal point).
3. Compare the accounts and amounts in the
trial balance with that in the ledger. Be
certain that no account is omitted.
4. Recompute the balance of each ledger
account.
5. Trace all 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.
Chapter 3
Adjusting the Accounts
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 information is valued
when it is communicated early enough to be
used for economic decision-making. To
provide timely information, accountants have
divided the economic life of a business into
artificial time periods. This assumption is
referred to as the periodicity concept.
Accounting periods are generally a
month, a quarter or a year. The most basic
accounting period is one year. Entities differ
in their choice of the accounting year- fiscal,
calendar or natural. A fiscal year is a period of
any twelve consecutive months. A calendar
year is an annual period 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.
Recognition and Derecognition
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.
Recognition is appropriate if it results
in both relevant information about assets,
liabilities, equity income and expenses and a
faithful representation of those items, because
the aim is to provide information that is useful
to investors, lenders and other creditors.
 Derecognition is the removal of all or part of a
recognized asset or liability from an entity’s
statement of financial position.
Derecognition normally occurs when that
item no longer meets the definition of an asset
or a liability.
a. For an asset, derecognition 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.
The need for Adjustment
Accountants make adjusting entries
to reflect in the accounts information on
economic activities that have occurred but
have not yet been recorded. Adjusting entries
assign revenues to the period in which they
are earned, and expenses to the period in
which they are incurred. These entries are
needed to measure properly the profit for the
period, and to bring related asset and liability
accounts to correct balances for the financial
statements.
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.
Deferrals and Accruals
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.
Adjustments for Deferrals (Step 5)
Allocating Assets to Expenses
Entities often make expenditures that
benefit more than one period. These
expenditures are generally debited to an asset
account. At the end of each accounting
period, the estimated amount that has expired
during the period or that has benefited the
period is transferred from the asset account to
an expense account. Two of the more
important kinds of adjustments are prepaid
expenses, and depreciation of property and
equipment.
Prepaid Expenses
Some expenses are customarily paid
in advance. These expenditures (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.
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
Depreciation of Property and
Equipment
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.
Accountants estimate periodic
depreciation. They have developed a number
of methods for estimating depreciation. The
simplest procedure is called the straight-line
method.
The asset account is not directly
reduced when recording depreciation
expense. Instead, the reduction is recorded in
a contract account called accumulated
depreciation. A contra account is used to
record reductions in a related account and its
normal balance is opposite that of the related
account. Use of the contra account –
accumulated depreciation – allows the
disclosure of the original cost of the related
asset in the balance sheet. The balance of the
contra account is deducted from the cost to
obtain the book value of the property and
equipment.
Allocating revenues Received in
Advance to Revenues
There are times when an entity
receives cash for services or goods even before
service is rendered or goods are delivered.
When such is received in advance, the entity
has an Obligation to perform services or
deliver goods. The liability referred to is
unearned revenues.
Adjustment for Accruals (Step 5)
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.
Accrued Interest (adj. h).
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 borrowed money – is received. The
interest is a fixed obligation and accrues
regardless of the result of the entity’s
operations.
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.
Chapter 4
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.
PREPARING THE WORKSHEET (step
5)
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 crossfooting. 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.
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.
Every account is either a balance
sheet account or an income statement
account. Asset, liability, capital and
withdrawal accounts are extended to the
balance sheet columns. Income and
expense accounts are moved to the
income statement columns. Debits in the
adjusted trial balance remain as debits in
the statement columns while credits as
credits. Each accounts adjusted balance
should appear in only one statement
column as shown in exhibit 4-4. At this
stage, the initial totals of the income
statement and balance sheet columns are
not equal.
5. Compute profit or loss as the difference
between total revenues and total expenses
in the income statement. Enter profit or
loss as a balancing amount in the income
statement and in the balance sheet, and
compute the final column totals.
The profit or loss should always be the
amount by which the debit and credit columns
for income statement, and the debit and credit
columns for balance sheet differ. The profit
figure of P35,000 is entered in the debit
column of the income statement and the
credit column of the balance sheet. After
completion, total debits and total credits in
the income statement and balance sheet
columns must equal.
The profit figure is extended to the credit
column of the balance sheet because profit
increases owner’s equity 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.
ESSENCE OF FINANCIAL
STATEMENTS
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.
COMPLETE SET OF FINANCIAL
STATEMENTS
Per revised PAS no. 1, a complete set of
financial statements comprises:
1. A statement of financial position as at
the end of the period;
2. A statement of financial performance
for the period;
3. A statement of changes in equity for
the period;
4. A statement of cash flows for the
period;
5. Notes, comprising a summary of
significant accounting policies and
other explanatory information; and
6. A statement of financial position as at
the beginning of the earliest
comparative period when an entity
applies an accounting policy
retrospectively or makes a
 retrospective restatement of items in
its financial statements or when it
reclassifies items in its financial
statements.
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.
PREPARING THE FINANCIAL
(step 6)
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)
Statement of Financial Performance
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.
Information about the performance
of an enterprise, in particular its profitability,
is required in order to assess potential
changes in the economic resources that it is
likely to control in the future. It is also useful
in predicting the capacity of the enterprise to
generate cash flows from its existing resource
base.
Statement of Changes in Equity
The statement of changes in equity
summarizes the changes that occurred in
owner’s equity. This statement is now a
required statement (per revised Philippine
Accounting Standards (PAS) no.1). Changes
in an enterprise’s equity between two balance
sheet dates reflect the increase or decrease in
its net assets during the period.
In the case of sole proprietorships,
increases in owner’s equity arise from
additional investments by the owner and
profit during the period. 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
Statement of Financial Position
The statement of financial position is
a statement that shows the financial position
or condition of an entity by listing the assets,
liabilities and owner’s equity as at a specific
date. The information needed for 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.
Statement of Cash Flows
The statement of cash flows provides
information about the cash receipts and cash
payments of an entity during a period. It is a
formal statement that classifies cash receipts
(inflows) and cash payments (outflows) into
operating, investing and financing activities.
This statement shows the net increase or
decrease in cash during the period and the
cash balance at the end of the period; it also
helps project the future net cash flows of the
entity. The discussion below gives an
overview of some important concepts
involved in the preparation of the cash flow
statement.
Cash Flows from Operating Activities
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.
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
Cash Flows from Investing Activities
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 Flows from Financing Activities
Financing activities include obtaining
resources from owners and creditors.
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
Cash Flows from Operating Activities:
Cash received from clients
Payments to suppliers
Payments to employees
Payments for office rent
Payments for insurance
Payments for utilities
Net cash provided by (used) operating activities
Cash Flows from Investing Activities:
Payments to acquire service vehicle
Payments to acquire office equipment
Net cash provided by (used in) investing activities
Cash Flows from Financing Activities:
Cash received as investments by owner
Cash received from borrowings
Payments for withdrawals by owner
Net cash provided by (used in) financing activities
 Net increase (decrease) in Cash
Cash balance at the beginning of the period
Cash balance at the end of the period
Relationships among the financial
statements
The financial statements are based on the
same underlying data are fundamentally
related. The following shows the basic
interrelationships among the financial
statements:
1. The income statement reports all income and
expenses during the period. The profit or loss
is the final figure in this statement.
2. The statement of changes in equity considers
the profit or loss figure from the income
statement as one of the determining factors
that 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.
ADJUSTMENTS ARE JOURNALIZED
AND POSTED (step 7)
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.
CLOSING ENTRIES ARE
JOURNALIZED AND POSTED (step 8)
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 P 22,200
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.
1. Close the income accounts
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 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.
2. Close the expense accounts
Expense accounts have debit
balances before the closing entries are
posted. For this reason, a compound entry is
needed crediting each expense account for its
balance and debiting the income summary
for the total. These data can be found in the
debit side of the income statement columns
of the worksheet.
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.
3. Close 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.
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.
4. Close the withdrawals account
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.
The effect of posting this closing
entry is to close the withdrawal account and
to transfer the balance to the capital account.
PREPARATION OF A POST-CLOSING
TRIAL BALANCE (step 9)
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.
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.
Chapter 6
Merchandising Operations
COMPARISON OF INCOME
STATEMENTS
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:
 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.
OPERATING CYCLE OF A
MERCHANDISING BUSINESS
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.
STEPS IN A PURCHASE
TRANSACTION
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.
The procedures are as follows:
1. When certain items are needed, the user
department fills in a purchase requisition
 form and sends it to the purchasing
department.
2. The purchasing department then prepares a
purchase order after checking with the price
lists, quotations, or catalogs of approved
vendors. The purchase order, addressed to
the selected vendor, indicates the quantity,
description, and price of the merchandise
ordered. It also indicates expected payment
terms and transportation arrangements.
3. After receiving the purchase order, the seller
forwards an invoice to the purchaser upon
shipment of the merchandise. The invoice –
called a sales invoice by the seller and a
purchase invoice by the buyer-defines the
terms of the transaction.
4. Upon receiving the shipment of merchandise,
the purchaser’s receiving department sees to
it that the terms in the purchase order are
complied with, and prepares a receiving
report.
5. Before approving the invoice for payment, the
accounts payable department compares
copies of the purchase requisition, purchase
order, receiving report and invoice to ensure
that quantities, descriptions, and prices agree.
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.
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.
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 treatment of transportation
costs
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.
Perpetual 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.
Periodic Inventory System
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
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.
Sales Returns and Allowances
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.
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.
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.
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.
Net Cost of Purchases
Under the periodic inventory
method, net cost of purchases consist of gross
purchases minus purchases discounts and
purchases returns and allowances equals net
purchases; plus transportation costs.
Purchases
When the periodic inventory method
is used, all purchases of merchandise are
debited to the purchases account.
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.
Purchases Returns and Allowances
Sales returns and allowances in the
seller’s books are recorded as purchases
returns and allowances in the books of the
buyer.
Purchases returns and allowances is a
contra account and is accordingly deducted
from purchases in the income statement. 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.
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.
VALUE ADDED TAX ENTRIES
The foregoing entries for sales and
purchases did not incorporate the effect of
value –added taxes on the transactions to
simplify the illustrations.
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.
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.
CHAPTER 7
Completing the Cycle for a
Merchandising Business
NEED FOR A PHYSICAL COUNT
In the periodic inventory system,
purchases of merchandise are accumulated in
the purchases account. During the accounting
period, no entry is made to the merchandise
inventory account such that its balance at the
end of the period, before adjusting and closing
entries, is the same as the beginning
inventory. With no perpetual record of the
cost of sales during the period, the only way to
obtain the cost of the ending inventory to
make a physical count.
PREPARING THE WORKSHEET
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.
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.
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.
PREPARING THE FINANCIAL
STATEMENTS
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.
Nature of Expense Method
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.
Function of Expense Method
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
for 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.
The difference between the two
methods lies in the items above operating
profit. The standard does not prescribe any
format. The choice between the two methods
depends on historical and industry factors
and the nature of the entity.
Statement of Changes in Equity
Balance Sheet
The balance sheet dated “December
31, 2019” is implicitly understood to mean “at
the close of business on December 31, 2019”
Classified Balance Sheet
ADJUSTING AND CLOSING ENTRIES
The adjusting entries are journalized
and posted to the ledger as they would be in a
service entity.
POST CLOSING TRIAL BALANCE
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.
CHAPTER 8
Manufacturing Operations
ACCOUNTING FOR MANUFACTURING
ACTIVITIES
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.
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.
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.
STATEMENT OF COST OF GOODS
SOLD
The difference in the income
statement of a merchandising and a
manufacturing entity lies in the cost of goods
sold section. As illustrated, observe that the
merchandiser used the term merchandise
inventory while the manufacturer used the
term finished goods inventory. A
merchandiser’s entire inventory is finished
goods; a merchandiser has no materials
inventory and work in process inventory.
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.
WORKSHEET FOR MANUFACTURING
ENTITY
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.
CHAPTER 9
Accounting for Payroll
ACCOUNTING FOR PAYROLL
Definition of Terms
1. 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.
2. Employer means a person for whom an
individual performs or performed any
service, of whatever nature, as the
employee of such person.
3. Payroll refers to the total amount paid to
employees for services provided during a
period.
4. 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.
Employees’ Payroll Deductions and
Employer’s Payroll Expenses
1. Contributions. The monthly contribution
are based on the compensation-basic
monthly salary plus cost of living
allowance – of the member and payable
under the three programs, as follows:
• Social Security Benefits -8.4% of
average monthly compensation not
exceeding P12,000 and payable by
both employer (5.04%) and
employee(3.36%)
• Philhealth Benefits-2.75% computed
straight based on the monthly basic
salary, with a salary floor of P10,000
and a ceiling of P40,000, to be
equally shared by the employee and
their employer (updated per
Philhealth Circular 2017-0024).
• Employee’s Compensation Benefits –
1% of average monthly compensation
not exceeding P1,000 and payable
only by the employer
To simplify, a contribution schedule is
provided to help determine the monthly
contributions of a member based on his
monthly salary credit. the monthly salary
credit is the compensation base for
contribution and benefits related to the total
earnings for the month. The contribution
schedule for employed members can be found
during the discussion of the payroll register.
Pag-IBIG Fund Contributions
• Employees earning not more than
P1,500 per month – 1%, or
Employees earning more
than P1,500 per month – 2%
• Employers – 2% of the monthly
compensation of the contributing
employee.
Monthly compensation shall mean basic
salary plus cost-of-living allowance (COLA).
Note that the maximum monthly
compensation to be used in computing
employee and employer contribution shall not
be more than P5,000; the effect will be a
maximum contribution of only P100. A
member may be allowed to contribute more
than what is required. The employer,
however, shall only be mandated to
contribute what is required unless the
employer agrees to match the employee’s
increased contribution.
2. Withholding Taxes
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
semimonthly 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.
The Payroll System
Expenditures for labor costs and related
payroll expenses are usually significant for
most business entities for several reasons:
• Employees are sensitive to payroll
errors or irregularities, and
maintaining good employee morale
requires that payroll be paid on a
timely and accurate basis.
• Payroll is subject to various
regulations.
• Payroll and other related expenses
have a significant effect on the net
income of most entities.
To make payroll accounting accurate and
timely, accountants have developed the
payroll system. The components of the
payroll system follow:
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.
Employee Earnings Record
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.
Pay Slip, Check or ATM
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.
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 10:
Partnerships: Basic Considerations
and Formation
DEFINITION
In a contract of partnership, two or more
persons bind themselves to contribute money,
property, or industry to a common fund, with
the intention of dividing the profit among
themselves. Two or more person may also
form a partnership for the exercise of a
profession (civil code of the Philippines,
article 1767).
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 reaemble 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.
A profession is an occupation that
involves a higher education or its equivalent,
and mental rather than manual labor. Strictly
speaking, the exercise of a profession is not a
business or an enterprise for profit but the law
allows two or more persons to act as partners
in the practice of their profession.
Partnerships are generally associated with the
practice of law, public accounting, medicine
and other professions. Partnerships of this
nature are called general professional
partnerships. On the other hand, service
industries, retail trade, whole sale and
manufacturing enterprises may also be
organized as partnership.
 CHARACTERISTICS OF A
PARTNERSHIP
The characteristics of partnership are
different from the sole proprietorships
already studied in basic accounting. Some of
the more important characteristics are as
follows:
1. Mutual Contribution. There cannot be
a partnership without contribution of
money, property or industry (i.e. work of
services which may either be personal
manual efforts or intellectual) to a
common fund.
2. Division of Profits or Losses. The
essence of partnership is that each
partner must share in the profits or losses
of the venture.
3. 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.
4. Mutual Agency. Any partner can bind
the other partners to a contract if he is
acting within his express or implied
authority.
5. 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.
6. 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.
7. 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.
Advantages and Disadvantages of a
partnership
A partnership offers certain
advantages over a sole proprietorship and
a corporation. It also has a number of
disadvantages. They are as follows:
Advantages versus Proprietorships
1. Brings greater financial capability to
the business.
2. Combines special skills, expertise and
experience of the partners.
3. Offers relative freedom and flexibility
of action in decision-making.
Advantages versus Corporations
1. Easier and less expensive to organize.
2. More personal and informal
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.
Partnership distinguished from
corporation
1. Manner of Creation. A partnership is
created by mere agreement of the
partners while a corporation is created by
operation of law.
2. Number of Persons. Two or more
persons may form a partnership; in a
corporation, at least five (5) persons, not
exceeding fifteen (15).
3. Commencement of Juridical
Personally. In a partnership, juridical
personality issuance of certificate of
incorporation by the Securities and
Exchange Commission.
 4. Management. In a partnership, every
partner is an agent of the partnership if
the partners did not appoint a managing
partner; in a corporation, management is
vested on the Board of Directors.
5. 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.
6. Right of Succession. In a partnership,
there is no right of succession; in a
corporation, there is right of succession.
A corporation has the capacity of
continued existence regardless of the
death, withdrawals, insolvency or
incapacity of its directors or
stockholders.
7. 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
A partnership may be constituted orally or in
writing. In the latter case, partnership
agreements are embodied in the Articles of
Partnership. The following essential
provisions may be contained in the
agreement.
1. The partnership name, nature, purpose, and
location;
2. The names, citizenship and residences of the
partners;
3. The date of formation and the duration of the
partnership;
4. The capital contribution of each partner, the
procedure for valuing non-cash investments,
treatment of excess contribution (as capital or
as loan) and the penalties for a partner’s
failure to invest and maintain the agreed
capital;
5. The rights and duties of each partner.
6. The accounting period to be adopted, the
nature of accounting records, financial
statements and audits by independent public
accountants;
7. The method of sharing profit or loss,
frequency of income measurement and
distribution, including any provisions for the
recognition of differences in contributions.
8. The drawings or salaries to be allowed to
partners;
9. The provision for arbitration of disputes,
dissolution, and liquidation.
A contract of partnership is void whenever
immovable property or real rights are
contributed and a signed inventory of the said
property is not made and attached to a public
instrument.
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).
• Submit the following documents:
1. Articles of Partnership
2. Verification slip for the Business
Name
3. Written undertaking to change
business name if required
4. Tax identification number
of each partner and/or that
of the partnership
Registration data sheet for
partnership duly
accomplished in six copies
• Other documents that may
be required:
1. Endorsement from other government
agencies if the proposed partnership
will engage in an industry regulated
by the government.
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.
ACCOUNTING FOR PARTNERSHIPS
Owners’ Equity Accounts
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.
Permanent withdrawals are made
with the intention of permanently decreasing
the partner’s capital while temporary
withdrawals are regular advances made by the
partners in anticipation of their share in
profit.
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.
Loans Receivable from or Payable to
Partners
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
Valuation of Investments by Partners
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 noncash 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.
Opening Entries of a Partnership Upon
Formation
A partnership may be formed in any of the
following ways:
1. Individuals with no existing business form a
partnership.
2. Conversion of a sole proprietorship to a
partnership.
a. A sole proprietor and an individual
without an existing business form a
partnership.
b. Two or more sole proprietors form a
partnership.
3. Admission or retirement of a partner (to be
covered in another accounting subject).
Individuals with no Existing Business Form a
Partnership
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.
A Sole Proprietor and Another
Individual Form a Partnership
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.
CHAPTER 11
PARTNERSHIPS: Operations and
Financial Reporting
Partners equity in assets contrasted
with share in profit or losses
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.
Factors to consider in arriving at a
plan for dividing
Money, Property or Industry
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.
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.
Rules for the distribution of profit or
losses
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:
• as to capitalist partners, the profits
shall be divided according to their
capital contributions (according to
the ratio of original capital
investments or in its absence, the
ratio of capital balances at the
beginning of the year).
• as to industrial partners (if any), such
share as may be just and equitable
under the circumstances, provided,
that the industrial partner shall
receive such share before the
capitalist partners shall divide the
profits
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.
CORRECTION OF PRIOR PERIOD
ERRORS
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.
Per International Accounting
Standard (IAS) no.8 Accounting Policies,
Changes in Accounting Estimates and Errors,
prior period errors are omissions from and
other misstatements of the entity’s financial
statements for one or more prior periods that
are discovered in the current period. Errors
,ay occur as a result of mathematical mistakes,
mistakes in applying accounting policies,
misinterpretation of facts, fraud or oversights.
Examples include errors in the estimation of
depreciation, errors in inventory valuation,
and omission of accruals of revenue and
expenses.
Material prior periods must be
restated to report financial position and
results of operations as they would have been
presented had the error never taken place.
The amount of the correction of a prior period
error that relates to prior periods should be
reported by adjusting the opening balances of
partners’ equity and affected assets and
liabilities. The correction of a prior period
error is excluded from profit or loss for the
period in which the error is discovered.
If an error resulted an
understatement of profit in previous periods,
a correcting entry would be needed to increase
capital. If an error overstated profit in prior
periods, then capital would have to be
decreased. The effect of the error correction
will be divided based on the applicable profit
and loss ratio.
DISTRIBUTION OF PROFITS OR
LOSSES BASED ON PARTNERS’
AGREEMENT
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.
Based on Partners’ Capital
Contributions
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.
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.
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.
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 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.
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).
By Allowing Salaries to Partners and
the Balance in an Agreed Ratio
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.
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.
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.
FINANCIAL REPORTING
Purpose of Financial Statements
Financial statements are a structured
representation with the objective of providing
information about the financial position,
financial performance and cash flows of an
entity that is useful to a wide range of users in
making economic decisions. Financial
statements also show the results of the
management’s stewardship of the resources
entrusted to it. To meet the objective,
financial statements provide information
about an entity’s assets, liabilities, equity,
income and expenses, other changes in equity
and cash flows.
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.
Frequency of Reporting and
Comparative Information.
At least annually, an entity shall
present with equal prominence each financial
statement in a complete set of financial
statements including comparative
information in respect of the previous period
for all amounts reported in the current
period’s financial statements.
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.
Complete Set of Financial Statements
Per revised International Accounting
Standards (IAS) no. 1, Presentation of
Financial Statements, a complete set of
financial statements comprises:
a. statement of financial position as at the
end of the period;
 b. a statement of financial performance for
the period;
c. a statement of changes in equity for the
period;
d. a statement of cash flows for the period;
e. notes, comprising a summary significant
accounting policies and other
explanatory information; and
f. a statement of financial position as at the
beginning of the earliest comparative
period when an entity applies an
accounting policy retrospectively or
makes a retrospective restatement of
items in its financial statements, or when
it reclassifies items in its financial
statements.
Statement of Financial Performance
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.
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:
f. 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;
g. Profit or loss;
h. Each component of other financial
performance classified by nature (excluding
amounts in (h) below);
i. Share of the other financial performance of
associates and joint ventures accounted for
using the equity method; and
j. Total financial performance.
Statement of Changes in Equity
An entity shall present a statement of
changes in equity, showing in the statement:
a. total financial performance for the period
showing separately the total amounts
attributable to owners of the parent and to
minority interests;
b. for each component of equity, the effects of
retrospective restatement recognized in
accordance with IAS no. 8 accounting
policies, changes in accounting estimates
and errors;
c. the amounts of transactions with owners
in their capacity as owners, showing
separately contributions by and
distributions to owners; and
d. for each component of equity, a
reconciliation between the carrying
amount at the beginning and the end of the
period, separately disclosing each change.
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.
Statement of Financial Position
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.
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:
a. Property, plant and equipment;
b. Investment property;
c. Intangible assets;
d. Financial assets (excluding amounts shown
under e, h and i);
e. Investment accounted for using equity
method.
f. Biological assets;
g. Inventories;
h. Trade and other receivables;
i. Cash and cash equivalents;
j. The total of assets classified as held for sale
and assets included in disposal groups
classified as held for sale in accordance with
IFRS 5;
k. Trade and other payables;
l. Provisions;
m. Financial liabilities (excluding amounts
shown under k and l);
n. Liabilities and assets for current tax, as
defined in IAS 12;
o. Deferred tax liabilities and deferred tax
assets, as defined in IAS12;
p. Liabilities in disposal groups classified as held
for sale in accordance with IFRS 5;
q. Minority interest, presented within equity;
and
r. Issued capital and reserves attributable to
equity holders of the parent.
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.
A liability should be classified as a current
liability when it:
• is expected to be settled in the normal
operating cycle; or
• is held primarily for the purpose of
trading; or
• is due to be settled within 12 months
after the end of the reporting period;
or
• does not have an unconditional right
to defer settlement of the liability for
at least 12 months after the reporting
period.
All other liabilities should be classified as non-
current liabilities.
The statement of cash flows has been
discussed in an earlier chapter.
Chapter 12
Corporations: Basic Considerations
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
1. The corporation has the legal capacity to acts
as a legal entity.
2. Shareholders have limited liability.
3. It has continuing of existence.
4. Shares of stock can be transferred without the
consent of the other shareholders.
5. Its management is centralized in the board of
directors.
6. Shareholders are not general agents of the
business.
7. Greater ability to acquire funds.
DISADVANTAGES OF A
CORPORATION
1. A corporation is relatively complicated in
formation and management.
2. There is a greater degree of government
control and supervision.
3. It requires a relatively high cost of formation
and operation.
4. It is subject to heavier taxation than other
forms of business organizations.
5. Minority shareholders are subservient to the
wishes of the majority.
6. In large corporations, management and
control have been separated from ownership.
7. Transferability of shares permits the uniting
of incompatible and conflicting elements in
one venture.
CLASSES OF CORPORATIONS
Section 3 of the Corporation Code classified
private corporations into:
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 nonstock
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).
OTHER CLASSIFICATIONS OF
CORPORATIONS
1. According to number of persons:
A. Corporation aggregate. A
corporation consisting of more than
one corporator.
B. Corporation sole or a special form of
corporation usually associated with
the clergy. It is a corporation which
consists of only one member or
corporator and his successors such as
a bishop.
2. According to nationality:
A. Domestic corporation. A corporation
organized under Philippine laws.
B. Foreign corporation. A corporation
organized under foreign laws.
3. According to whether for public or private
purpose:
A. Public corporation. A corporation
formed or organized for the
government of a portion of the state
(e.g., provinces, cities, municipalities
and barangays).
B. Private corporation. A corporation
created for private aim, benefit or
purpose.
4. According to whether for charitable purpose
or not:
A. Ecclesiastical corporation. Those
organized for religious purposes.
B. Eleemosynary corporation. Those
established for public charity.
C. Civil corporation. Those established
for business or profit.
5. According to their legal right to corporate
existence.
A. De jure corporation. A corporation
existing in fact and in law. It is
organized in strict conformity with
the law.
B. De facto corporation. A corporation
existing in fact but not in law.
6. According to degree of public participation
with regard to share ownership.
A. Close corporation. A corporation
whose share ownership is limited to
selected persons or members of a
family not exceeding 20 persons.
B. Open corporation. A corporation
where the share is available for
subscription or purchase by any
person.
C. Publicly –held corporation.
corporation with a class of equity
securities listed on an exchange or
with assets in excess of P50,000,000
and having 200 or more holders, at
least 200 of which are holding at least
100 shares of a class of its equity
securities (SRC rule 3-1.M, amended
IRR of the Securities Regulations
code (RA 8799).
7. According to their relation to another
corporation:
A. Parent or holding corporation. A
corporation that is related to another
corporation that it has the power to
either directly or indirectly elect the
majority of the directors of a
subsidiary corporation.
B. Subsidiary corporation.
corporation controlled by another
corporation known as a parent
corporation.
STEPS IN THE CREATION OF A
CORPORATION
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
A 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
A 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.
3. Formal organization and
commencement of business
operations. Formal organization
requires the adoption of by-laws and the
 election of the board of directors and of
the administrative officers. It also
includes the taking of such other steps as
are necessary to enable the corporation
to transact the legitimate business or
accomplish the purpose for which was
created.
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.
However, if a corporation has
commenced business but subsequently
becomes continuously inoperative for a
period of at least five (5) years, the same shall
be a ground for the suspension or revocation
of its certificate of incorporation.
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:
1. The name of the corporation;
2. The specific purpose or purposes for which
the corporation is formed.
3. The principal place of business which must be
within the Philippines;
4. The term of existence;
5. The names, nationalities and residences of the
incorporators;
6. The number of directors or trustees, which
shall not be less than five (5) nor more than
fifteen (15);
7. The names, nationalities and residences of the
persons who shall act as directors or trustees
until the first regular directors or trustees are
elected and qualified.
8. If it be a stock corporation:
a. Amount of authorized share capital in pesos,
b. Number of shares into which it is divided,
c. In case the shares are par value shares:
• the par value of each share,
•names, nationalities and residences
of the original subscribers.
• the amount subscribed and paid by
each subscriber on his subscription.
d. In case of no par value, the articles need only
state such fact, and the number of shares
into which said share capital is divided.
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
The following are some of the rights of a
shareholder:
1. Right to be issued certificate of stock or other
evidence of share ownership and to transfer
such shares.
2. Right to attend and vote in person or by proxy
at shareholders’ meeting.
3. Right to elect and remove directors.
4. Right to adopt, amend or repeal the by-laws.
5. Right to purchase a portion of any new shares
issued to maintain the same percentage of
stock ownership. This right is known as the
pre-emptive right. However, this right is not
absolute and may be denied.
6. Right to receive dividends when declared.
7. Right to inspect corporate books and records,
and to receive financial reports of the
corporation’s operations.
8. Right to participate in the distribution of
corporate assets upon dissolution.
COMPONENTS OF A CORPORATION
1. Corporators are those who compose a
corporation whether as shareholders or
members, at anytime. This term includes
incorporators, shareholders or members (Sec.
5). Note: A corporation or a partnership can
be a corporator, but cannot be an
incorporator. A partnership can be a
corporator in a corporation but a corporation
cannot be a general partner in a partnership.
2. Incorporators are shareholders or
members mentioned in the articles of
incorporation as originally forming and
composing the corporation and are
signatories to said articles of Incorporation
(section 5). They must be natural persons (i.e.
human beings) as distinguished from artificial
beings (e.g., a corporation or a partnership).
An incorporator will always retain his status
as such though no longer having an interest in
the corporation.
3. Shareholders or stockholders are
corporators in a stock corporation (section 5).
Shareholders may be natural or juridical
persons.
4. Members are corporators of a non-stock
corporation (section 5).
5. Subscribers are persons who have agreed to
take and pay for original, unissued shares of a
corporation formed or to be formed. Note: all
incorporators are subscribers but a subscriber
need not be an incorporator.
6. Promoters are persons who bring about or
cause to bring about the formation and
organization of a corporation.
7. Underwriters are usually investment
bankers who have
• agreed, alone or with others, to buy at
stated terms an entire or a substantial
part of an issue of securities; or
• guaranteed the sale of an issue by
agreement to buy from the issuing
corporation any unsold portion at a
stated price; or
• agreed to use his best efforts to
market all or part of an issue; or
• offered for sale shares he has
purchased from a controlling
stockholder.
8. Independent director is a person who
apart from his fees and shareholdings is
independent of management and free from
any business or other relationship which
could, or could reasonably be perceived to,
materially interfere with his exercise of
independent judgment in carrying out the
responsibilities of a director.
A publicly-held corporation, as
earlier defined, shall have at least two
independent directors or at least 20% of the
member of the board, whichever is the lesser
(section 38 of the SRC). This is being done to
protect the interest of the shareholders and
investors. The election of the independent
directors is done during the annual
stockholders meeting by the stockholders
themselves.
CLASSES OF SHARES IN GENERAL
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.
4. Voting shares. Those issued with the right to
vote.
5. Non-voting shares. Those issued without the
right to vote.
6. Ordinary shares. These shares entitle the
holder to an equal pro-rata division of profits
without any preference.
7. Preference shares. These shares entitle the
holder to certain advantages or benefits over
the holders of ordinary shares.
8. Promotion shares. Those issued to promoters
as compensation in promoting the welfare of
the corporation.
9. Treasury shares. A stock that has been issued
by the corporation as fully paid and later
reacquired but not retired.
10. Convertible shares. A stock which is
convertible or changeable from one class to
another class.
MINIMUM SUBSCRIPTION AND PAID
– IN CAPITAL
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.
BASIC CORPORATE
ORGANIZATIONAL STRUCTURE
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.
Hierarchy of Corporate Structure
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).
CORPORATE BOOKS AND RECORDS
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.
Chapter 13
CORPORATION: Share Capital,
Retained Earnings and Financial
Reporting
OVERVIEW OF SHAREHOLDERS’
EQUITY
Generally, the type of business
organization-sole proprietorship, partnership
or corporation, does not affect the asset and
liability sections of the statement of financial
position. The only difference in the owners’
equity sections. Sole proprietorships and
partnerships use capital accounts and
ultimately combine the owners’ contributions
and accumulated profits in accordance with
some legal provisions
The owners’ equity section of a
corporation’s statement of financial position
is called shareholders’ equity. Shareholders
equity has two major components – share
capital (contributed or paid –in capital) and
retained earnings. Share capital reflects the
amount of resources received by a corporation
as a result of investment by shareholders,
donation or other share capital transactions.
Retained earnings (or accumulated profits or
losses) is the amount of capital accumulated
and retained through the profitable
operations of the business.
SHARE CAPITAL
It is the shares to be subscribed and
paid in or secured to be in by the shareholders,
either in money, property or services, at the
time of organization of the corporation or
afterwards, and upon which it is to conduct its
operations. The share, contributed or paid-in
capital is further divided into the following:
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.
TWO BASIC TYPES OF SHARES
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:
1. 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.
2. 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).
TERMS RELATED TO SHARE
CAPITAL
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.
ACCOUNTING FOR ISSUANCE OF
SHARE CAPITAL
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.
CONSIDERATIONS FOR ISSUANCE
OF SHARES
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.
Accounting for share issue costs is
covered in paragraph 37 of International
Accounting Standard (IAS) no. 32, Financial
Without Par Value
When shares without par value are
sold, the proceeds should be credited to the
ordinary share account. Accounting for
issuance of preference shares is basically the
same as that of ordinary shares. Note,
however, that Section 6 of the Corporation
Code prohibits the issue of no-par value
preference shares.
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.
Subscriptions Receivable is a
shareholders’ equity account. It is presented
in the statement of financial position as a
deduction from the related subscribed
ordinary shares; however, when it is
collectible within one year, this may be shown
as a current asset. It is debited for the total
proceeds of the subscriptions to the ordinary
shares and credited for the collections on the
subscriptions.
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.
If there is no bidder, the corporation
may bid for the delinquent shares and the
total amount due shall be credited as paid in
full in the books of the corporation. These
shares shall be considered as treasury shares.

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.
Paragraph 33 of International
Accounting Standard (IAS) no.32, Financial
Instruments: presentation, states that, if an
entity reacquires its own equity instruments,
these instruments (treasury shares) shall be
deducted from equity. No gain or loss shall be
recognized in profit or loss on the purchase,
sale issue or cancellation of an entity’s own
equity instruments. Such treasury shares may
be acquired and held by the entity or by other
members of the consolidated group.
Consideration paid or received shall be
recognized directly in equity.
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.
Purchase of Treasury Stock
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.
Retirement of Treasury Stock
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.
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.
OVERVIEW OF RETAINED EARNINGS
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
Retained earnings is not a cash fund
waiting to be distributed as dividends.
Instead, it is an owners’ equity account
representing claim on all assets in general and
not on any asset in particular. In fact, the
corporation may have a sizeable balance in
this account but may not have cash to pay a
cash dividend. Shareholders are not
guaranteed dividends and dividends do not
become a liability of the corporation until the
board of directors has formally declared a
dividend distribution. Section 43 of the
Corporation Code states that dividends
should only be declared out of the
unrestricted retained earnings. Thus,
dividends cannot be declared out of the legal
capital of the corporation for the security of its
creditors.
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:
1. 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.
2. 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.
3. 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
Majority of dividends distributed by
corporations is paid in cash. In declaring cash
dividends, a corporation must have both an
appropriate amount of retained earnings and
the necessary amount of cash. Some investors
view that a large retained earnings balance
automatically permits generous dividend
distributions.
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.
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
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.
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.
Large Share Dividend
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.

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.

STATEMENT OF RETAINED
EARNINGS
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 P 280,000

the end of the period.