FAR Prefinal

Financial Accounting and Reporting I
Module Content || Week 9 to 14

Lesson: Module 9 to 14
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Session 9: Accounting Cycle of a Service Business
Module Learning Objectives:

1. Prepare a worksheet.
2. Prepare closing entries.
3. Prepare a balance sheet and income statement of a service business.
4. Prepare reversing entries.
Welcome to this module!

The first five steps were already discussed in the previous modules. In this module, we will
discuss the remaining steps to complete the accounting cycle of a service business. As discuss in
week 1, service business is one that offers services as its main product rather than offering
physical goods.
Activate Prior Knowledge:

Imagine you are planning to open a new business with a capital of P2, 000. What type of
business would it be? What will be your product/service?
Now, let’s acquire new knowledge!

The WORKSHEET
-it is used to help transfer data from the unadjusted trial balance to the financial statements although
optional and not part of the formal accounting records. This is a multi-column document that provides an
efficient way to summarize the data for financial statements. It is an analytical device used to facilities
the gathering of data for adjustments, the preparation of financial statements and closing entries.
To better illustrate the preparation of worksheet, let’s follow the steps of the accounting cycle.
Illustration: WORKSHEET
Ms. Rosamund Watson opened up a computer repair shop, called “Teckson Repair Shop” on December 1,
20x2. The following were the transactions during the month:
1. The owner provided P50, 000 cash as initial investment to the business on December 1, 20x2.
2. Obtained a 10%, one-year, bank loan for P50, 000 on December 1, 20x2. Principal and interest are
due at maturity date.
3. Paid four months’ rent in advance of P20, 000 on December 1, 20x2. Rent per month is P5, 000.
4. Acquired an equipment that has a useful life of 5 years, P30, 000.
5. Purchased supplies for P20, 000 cash during the period.
6. Rendered services worth P60, 000 for cash and P18, 000 on credit during the period.
7. The owner withdrew P25, 000 cash from the business during the period.
CARD-MRI Development Institute, Inc.

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Requirement: Prepare the worksheet on December 31, 20x2.
Solutions:
Steps 1 & 2: Identifying and analyzing transactions and events and Journalizing
The transactions are recorded in the journal as follows:
(1) Cash P 50, 000

Watson, Capital P50, 000
To record the owner’s investment to the business
(2) Cash P 50, 000

Notes payable P 50, 000
To record the bank loan
Using the ASSET METHOD:

(3a) Prepaid Rent P 20, 000
Cash P 20, 000
To record the payment of rent
Using the EXPENSE METHOD:

(3b) Rent Expense P 20, 000
Cash P 20, 000
To record the payment of rent
Note: Both the entries in (3a) and (3b) above are acceptable. However, Teckson should only choose one
method as its accounting policy (either asset method or expense method) and apply that policy
consistently in the current and succeeding accounting periods (Consistency Concept). On this illustration,
let us assume Teckson chose to use the expense method.
(4) Equipment P 30, 000

Cash P 30, 000
To record the acquisition of equipment for cash
Using the ASSET METHOD:

(5a) Prepaid supplies P 20, 000
Cash P 20, 000
To record the purchase of supplies
Using the EXPENSE METHOD:

(5b) Supplies Expense P 20, 000
Cash P 20, 000
To record the purchase of supplies
Again, we will assume that Teckson chose to use the expense method.

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For single entry:
(6) Cash P 60, 000

Service revenue P 60, 000
To record the service income
Accounts receivable P 18, 000

For compound entry:

(6) Cash P 60, 000
Accounts Receivable 18, 000
(7) Watson, Drawings P 25, 000

Cash P 25, 000
To record the owner’s drawings
Step 3: Posting
The journal entries are posted to the ledgers as follows:
ASSETS
CASH ACCOUNTS RECEIVABLE

(1) 50, 000 (3B) 20, 000 (6) 18, 000
(2) 50, 000 (4) 30, 000 Bal. P 18, 000
(6) 60, 000 (5B) 20, 000
(7) 25, 000
Bal. P 65, 000 EQUIPMENT
(4) 30, 000
Bal. P 30, 000
LIABILITIES
NOTES PAYABLE
(2) 50, 000
Bal. P50, 000

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EQUITY
WATSON, CAPITAL WATSON, DRAWING

(1) P 50, 000 (7) P 25, 000
Bal. P50, 000 Bal. P 25, 000
INCOME EXPENSES
SERVICE REVENUE SUPPLIES EXPENSE

(6) P 78, 000 (5) P 20, 000
Bal. P78, 000 Bal. P 20, 000
RENT EXPENSE
(3) P20, 000
Bal. P 20, 000
STEP 4: UNADJUSTED TRIAL BALANCE
The unadjusted trial balance on December 31, 20x2 is prepared as follows:

TECKSON REPAIR SHOP
Unadjusted Trial Balance
December 31, 20x2
Accounts Debits Credits
Cash P 65, 000
Equipment 30, 000
Notes Payable P 50, 000
Watson, Capital 50, 000
Watson, Drawings 25, 000
Service Revenue 78, 000
Supplies Expense 20, 000
Rent Expense 20, 000
Totals P 178, 000 P 178, 000
STEP 5: ADJUSTING ENTRIES

Additional information:
The following information was identified on December 31, 20x2:
1.) The water and electricity bills in December amounting to P2, 800 are not yet paid.
2.) The cost of unused supplies is P12, 900.

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Before we move on, let us recall the common adjusting entries. These will become our
guide in identifying the needed adjustments.
1. Accruals of income and expense
2. Recognition of depreciation expense and bad debts expense
3. Deferrals of income and expenses (splitting the mixed accounts).
Guide Analyses
1. Accruals of income and expenses  The cost of water and electricity already
used but not yet paid must be accrued as
expense.
 Teckson Repair Shop has note payable.

Therefore, interest expense shall be
accrued for the period.
2. Recognition of depreciation expense  Teckson Repair Shop has equipment.
Depreciation expense shall be recognized
for the period.
3. Deferrals of income and expenses (splitting of  Teckson prepaid 4 months’ worth of rent.
“mixed accounts”). One month of the total 4 months has been
used. This portion shall be recognized as
expense; the remainder as asset.
 Of the total supplies purchased during the

period, P 12, 900 remains unused. The
unused portion shall be recognized as
asset; the remainder as expense.
From our analyses, we have identified adjustments for the following:

1. Utilities expense for the cost of electricity and water used but not yet paid;
2. Interest expense on the note payable;
3. Depreciation expense on the equipment;
4. Rent expense for the used portion, and prepaid rent (asset) for the unused portion, or the rent paid in
advance; and
5. Supplies expense for the used portion, and prepaid supplies (asset) for the unused portion, of the total
supplies purchased during the period.
Let’s start taking up the adjustments:

AJE #1: Utilities expense
The water and electricity bills in December amounting to P2, 800 are not yet paid.
Dec. 31, 20x2 Utilities expense 2, 800

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Utilities payable 2, 800
To accrue utilities expense
incurred but not yet paid
AJE #2: Interest expense
i = Prt r = 10%
P = 50, 000 t = 1 month passed (December 1 to December 31,
Interest expense = (50, 000 x 10% x 1/12) 20x2) over 12 months in a year or (1/12)
Dec. 31, 20x2 Interest expense 416.67

Interest payable 416.67
To accrue interest expense
incurred but not yet paid
AJE #3: Depreciation Expense

The annual depreciation expense is computed as follows:
Cost of equipment P 30, 000
Divide by: Useful life 5
Annual depreciation expense P 6, 000
Observe that the depreciation is at annual basis, however, because the equipment has been used for 1
month in 20x2 (December 20x2), only a 1-month depreciation expense shall be recognized.
Annual depreciation P 6, 000

Multiple by: 1/12
Depreciation expense- Dec. 20x2 P 500
Shortcut: (P30, 000 x 1/5 x 1/12) = P 500
Dec. 31, 20x2 Depreciation expense 500

Accumulated Depreciation 500
To record the depreciation
expense for the period
The carrying amount of the equipment as of December 31, 20x2 is determined as follows:
Equipment P 30, 000

Accumulated Depreciation ( 500)
Equipment, net P 29, 500
AJE #4: Rent Expense

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From the initial recording of the 4-month rent, we assume Teckson opted to use expense method. When
the business used expense method, the adjusting entry is to take up the asset (unused or unexpired)
portion (i.e., the opposite). The adjusting entry therefore involves debiting “Prepaid rent” for the
unexpired portion of P20, 000 and crediting rent expense for the same amount.
Dec. 31, 20x2 Prepaid Rent 15, 000

Rent Expense 15, 000
To record the prepaid
rent for the period
After taking up the adjustment, the prepaid rent will now have a balance of P15, 000 (the unexpired
portion of rent paid in advance) while the rent expense will now have a balance of P 5, 000 representing
the expired portion of the rent paid in advance.
AJE #5: Supplies expense
From the initial recording of the supplies, we assume Teckson to used expense method. Again, when the
business used expense method, the adjusting entry is to take up the asset (unused or unexpired) portion
(i.e., the opposite). The adjusting entry therefore involves debiting “Prepaid supplies” for the unexpired
portion of P20, 000 and crediting supplies expense for the same amount.
Dec. 31, 20x2 Prepaid supplies 12, 900

Supplies Expense 12, 900
To record the prepaid
supplies for the period
After taking up the adjustment, the prepaid supplies will now have a balance of P12, 900 (the unused
portion of supplies) while the supplies expense will now have a balance of P 7, 100 representing the used
portion of the supplies.
Step 6: Adjusted Trial Balance

TECKSON REPAIR SHOP
Worksheet
For the month ended December 31, 20x2
Accounts Unadjusted trial balance AJE Adjustments AJ Adjusted trial balance
#’s E
#’
s
Dr. Cr. Dr. Cr. Dr. Cr.
Cash P 65, 000 P 65, 000
Accounts Receivable 18, 000 18, 000
Equipment 30, 000 30, 000
Notes payable P 50, 000 P 50, 000

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Watson, Capital 50, 000 50, 000
Watson, Drawings 25, 000 25, 000
Service Revenue 78, 000 78, 000
Rent expense 20, 000 #4 15, 000 5, 000
Supplies expense 20, 000 #5 12, 900 7, 100
Totals P178, 000 P178, 000
Adjustments:
Utilities expense #1 P 2, 800 P 2, 800
Utilities payable #1 2, 800 2, 800
Interest expense #2 416. 67 416. 67
Interest payable #2 416. 67 416. 67
Depreciation expense #3 500 500
Accum. Depreciation #3 500 500
Prepaid rent #4 15, 000 15, 000
Prepaid supplies #5 12, 900 12, 900
Totals P 31, 616.67 P 31, 616.67 P 181, 716.67 P 181, 716.67
Notes: Worksheet Preparation
1. Account titles used in the adjusting entries but were not previously included in the unadjusted trial
balance are places at the bottom part of the “Accounts” column of the worksheet.
2. The debits and credits of the adjusting entries are then placed on the “Adjustments” column of the
worksheet.
3. Amounts in the “Unadjusted trial balance” and “Adjustments columns are combined to come up with
the adjusted balances of the accounts. The adjusted balances are placed on the “Adjusted trial balance”
columns.
To combine the amounts, observe the rules of debits and credits:

a. Debit and debit means you add.
b. Credit and credit means you add.
c. Debit and credit, or vice versa, means you subtract.
Accounts Unadjusted trial balance AJE Adjustments AJE Adjusted trial balance
#’s #’s
Rent expense 20, 000 15, 000 5, 000
P 20, 000 in the unadjusted trial balance minus

the adjustment of P 15, 000 equals P 5, 000
adjusted trial debit balance. CARD-MRI Development Institute, Inc.
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The procedure to compute for the adjusted balances of the accounts in the adjusted trial balance is called
“cross-footing” (involves adding (or subtracting) amounts horizontally.
Accounts Unadjusted trial balance AJE Adjustments AJE Adjusted trial balance
#’s #’s
Supplies expense 20, 000 12, 900 7, 100
Total
Prepaid supplies 12, 900 12, 900

Total
Observe that the total debits and credits in the columns of the worksheet are equal.
The procedure to compute for the “totals” of the columns is called “footing” (involves adding (or
subtracting) amounts vertically.
Step 7: Preparing Financial Statements
Financial statements are the end product of the accounting process. Information from the journal and the
ledger are meaningless to most users unless they are summarized and communicated through the
financial statements.
In this modules, we will only prepare the following financial statements:

1. Statement of financial position (or Balance sheet)- it shows the information on assets, liabilities and
equity.
2. Statement of profit or loss (or Income statement) – it shows information on income and expenses, and
consequently, the profit or loss for the period.
The preparation of the balance sheet and the income statement is greatly facilitated by the
worksheet. In the worksheet, all income and expenses accounts in the adjusted trial balance are
extended to the “income statement columns,” while all asset, liability and equity are extended to the
“balance sheet columns.”
Illustration: Let us prepare the financial statement of Teckson Repair Shop.
Remember:
Income – expenses = profit or loss. If income exceeds expenses, there is profit. If expenses exceeds income, there is loss.
Profit or loss is closed to the Owner’s Capital account at the end of each period. Profit increases equity, while loss
decreases equity
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Thus, in the income statement columns of the worksheet:
 If total credits exceed total debits, there is profit. This is because total credits in the income
statement columns pertains to income, while total debits pertain to expenses.
o Therefore, if total credits exceed total debits in the income statement columns, the
balancing figure is on the debit side.
 If total debit exceed total credits, there is loss. In this case, income is less than expenses.
The balancing figure is the loss and it is placed on the credit side of the income statement
columns.
Thus, in the balance sheet columns of the worksheet:
 If total debit exceed total credits, there is profit. This is because the balancing figure on the
credit side will be added to equity when closing entries are made.
 If total credits exceed total debits, there is loss. This is because the balancing figure on the
debit side will be deducted from equity when closing entries are made.
Step 8: Closing the books

Before we present the balance sheet and income statement on formal reports, let us prepare first the
closing entries and port-closing trial balance.
What is closing entries?

These are entries made at the end of the accounting period to “zero out” all nominal accounts in the
ledger. This is done so that the transactions during the period will not commingle with the transactions in
the next period. Preparing closing entries also referred to as closing the books. This is an application of
time period concept.
Closing entries are prepared as follows:

1. All income accounts are debited and all expense accounts are credited. The resulting balance is
recorded in a clearing account called the “Income summary.”
2. The balance of “Income summary” is closed to the “Owner’s capital” account.
3. Any balances in the “Owner’s drawings” account is closed to the “Owner’s capital” account.

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Going back to the illustration of Teckson Repair Shop, let us prepare the closing entries.
TECKSON REPAIR SHOP
Worksheet
Accounts Income statement Balance sheet
Dr. Cr. Dr. Cr.
Cash P 65, 000
Equipment 30, 000
Watson, Capital 50, 000
Watson, Drawings 25, 000
Service Revenue P 78, 000
Rent expense P 5, 000
Supplies expense 7, 100
Totals
Adjustments:
Utilities expense 2, 800
Interest expense 416. 67
Depreciation expense 500
Accum. Depreciation 500
Prepaid rent 15, 000
Prepaid supplies 12, 900
Totals P 15, 816. 67 P 78, 000 P 165, 900. 00 P 103, 716. 67
62, 183.33 62, 183.33
P 78, 000 P 78, 000 P 165, 900. 00 P 165, 900. 00
Closing entry #1: Income summary

The income and expense accounts are closed to the “Income summary” account as follows:
Dec. 31, 20x2 Service revenue 78, 000

Rent expense 5, 000
Interest expense 416.67

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Income summary 62, 183.33
To close income and expense
Accounts to income summary
The amount in the income summary account is the balancing figure in the closing entry. This amount
represents the profit (or loss) for the period. Notice that this is the same amount of balancing figure in
the worksheet.
Notes:
If the “Income summary” account has a credit balance, there is profit, otherwise, there
is loss.
Closing entry #2: Income summary closed to Equity
The income summary is closed to the “Owner’s capital” account as follows:
Dec. 31, 20x2 Income summary 62, 183.33

Watson, capital 62, 183.33
To close the income summary
To equity
If the “income summary” is debited when closing to equity, there is profit. If the “income summary” is
credited when closing to equity, there is loss. These are because profit increases equity, while loss
decreases equity.
Closing entry #3: Drawings account closed to Equity

The Owner’s drawings account is closed to the Owner’s equity account as follows:
Dec. 31, 20x2 Watson, capital 25, 000

Watson, drawings 25, 000
To close the drawings account
To equity
The drawings account is closed directly to the “Owner’s capital” account rather than through the income
summary account because drawings account is neither an income nor an expense account but rather a
contra equity account. As such, owner’s drawings do not enter into the computation of profit or loss.
Step 9: Preparing the post-closing trial balance
The columns in the worksheet can be extended by adding columns for the following:
1. Closing entries- the debits and credits in the closing entries are placed here.

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2. Post-closing trial balance- the amounts in the “Adjusted trial balance” (or the Income statement and
Balance sheet) are cross-footed with the amounts in the “Closing entries” columns. The resulting
amounts are then placed in the “Post-closing trial balance.”
The amounts in the Post-closing trial balance will be the beginning balances of accounts in the
next accounting period.
After both the adjusting entries and closing entries are posted, the general ledger accounts of the
Teckson Repair Shop will have the following balances.
ASSETS
CASH ACCOUNTS RECEIVABLE

(1) 50, 000 (3B) 20, 000 (6) 18, 000
(2) 50, 000 (4) 30, 000 Bal. P 18, 000
(6) 60, 000 (5B) 20, 000
(7) 25, 000
Bal. P 65, 000 EQUIPMENT
(4) 30, 000
Bal. P 30, 000
PREPAID RENT
AJE #4 P 15, 000
Bal. P 15, 000
ACCUM. DEPRECIATION
P 500 AJE#3
Bal. P 500
PREPAID SUPPLIES
AJE #5 P 12, 900
Bal. P 12, 900
LIABILITIES
NOTES PAYABLE UTILITIES PAYABLE

P 50, 000 P 2, 800 AJE #1
Bal. P 50, 000 Bal. P 2, 800

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INTEREST PAYABLE
P 416. 67 AJE #2
Bal. P 416. 67
EQUITY
WATSON, CAPITAL WATSON, DRAWING

CL E#3 P 25, 000 P 50, 000 P 25, 000 P 25, 000 CL E#3
62, 183.33 CL E#2 Bal. P 0
Bal. P 87, 183.33
INCOME EXPENSES
SERVICE REVENUE SUPPLIES EXPENSE

CL E#1 P78, 000 (6) P 78, 000 P 20, 000 P12, 900 AJE #5
Bal. P 0 7, 100 CL E#1
Bal. P 0
RENT EXPENSE
(3) P 20, 000 P 15, 000 AJE#4
5, 000 CL E#1
Bal. P 0
UTILITIES EXPENSE
AJE #1 P2, 800 P 2, 800 CL E#1
Bal. P 0
INTEREST EXPENSE
AJE #1 P 416.67 P 416.67 CL E#1
Bal. P 0
DEPRECIATION EXPENSE
AJE #1 500 P500 CL E#1
Bal. P 0

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Notes:
 After closing entries are posted, the nominal accounts have zero balances. At this point, these
accounts are referred to as closed accounts.
o Closed account- an account that has no balance.
o Open account- an account that has a balance.
 The post-closing trial balance contains only real account (asset, liability, and equity accounts).
The post-closing trial balance is similar to the balance sheet columns in the worksheet except
that the balance of the Owner’s capital account is the updated amount after closing profit or loss
and drawings.
Columns in the worksheet Type of accounts contained in Equality of debits and credits
the columns
Unadjusted trial balance Real, nominal and mixed Debits and credits are equal
accounts
Adjusted trial balance Real and nominal accounts Debits and credits are equal
Income statement Nominal accounts only The difference between debits
and credits represents profit or
loss.
Balance sheet Real accounts only The difference between debits
and credits represents profit or
loss.
Post-closing trial balance Real accounts only Debits and credits are equal
The income statement is usually prepared first before the balance sheet. This is because the balance
sheet cannot be finalized until after profit or loss is determined and closed to equity. Thus, in the
worksheet, the income statement columns precede the balance sheet and post-closing trial balance
columns.
TECKSON LREPAIR SHOP

Balance Sheet
As of December 31, 20x2
ASSETS
Cash P 65, 000
Accounts receivable 18, 000
Equipment 30, 000
Accumulated depreciation (500)
TOTAL ASSETS P 140, 400.00
LIABILITIES

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TOTAL LIABILITIES P 53, 216. 67
EQUITY
Watson, capital P 87, 183.33
TOTAL EQUITY P 87, 183.33
TOTAL LIABILITIES AND EQUITY P 140, 400
TECKSON LREPAIR SHOP

Income statement
INCOME
EXPENSES
Rent expense (5, 000)
Supplies expense (7,100)
Utilities expense (2,800)
Interest expense (416.67)
Depreciation expense (500)
TOTAL EXPENSES (15, 816, 67)
PROFIT FOR THE PERIOD P 62, 183.33
Notes:
The heading of the financial statements show the following:
1. Name of the business (will answer the question ‘Who?’)
2. Title of the financial statement (will answer the question ‘What?’)
3. Reporting period (will answer the question ‘When?’)
The balance sheet is dated as of the end of the reporting period because it contains only real accounts
that are not closed at the end of each reporting period but rather carried over to the next period. Thus,
the balances these accounts represent cumulative amounts.
The income statement is dates covering the reporting period. This is because it contains the nominal
accounts that are closed at the end of each reporting period and are not carried over to the next period.
Thus, the balances of these accounts pertain only to the current period.
Step 10: Recording the reversing entries

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What is reversing entry?
- Usually made on the first day of the next accounting period to reverse certain adjusting entries in
the immediately preceding period.
- These entries are optional meaning they are not required in the preparation of the financial
statements. However, businesses often use reversing entries to simplify the recording process in
the next accounting period.
Purpose of reversing entries:

1. To facilitate the recording of cash receipts and disbursements in the next accounting period;
2. To promote convenience in recording the next period’s year-end adjustments for accruals; and
3. To promote consistency of accounting procedures.
What are the adjusting entries that may be REVERSED?

Not all adjusting entries may be reversed. Only the adjusting entries made for the following may
be reversed:
1. Accruals for income or expense
2. Prepayments initially recorded using the expense method
3. Advanced collections initially recorded using the income method
Let’s continue the accounting cycle of Teckson Repair Shop. The adjusting entries are re-provided below:

AJE #1
AJE #2
AJE #3
Accumulated depreciation 500
AJE #4
Rent expense 15, 000
AJE #5
Using the guide provided above, the adjusting entries that may be reversed are identified as follows:
Guide AJE’s that may be reversed
I. Accruals for income or expense 1. AJE #1 (unpaid utilities)
2. AJE #2 (unpaid interest)
II. Prepayments (expense method) 3. AJE #4 (prepaid rent)
4. AJE #5 (prepaid supplies)
III. Advanced collections (income method) None in this illustration
Hints:
- AJE’s involving “receivables” and “payables” are normally reversible.
- AJE’s involving “depreciation” and “bad debts” are not reversible.

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The reversing entries (RE) are prepared as follows:

RE #1
RE #2
Rent expense 15, 000
RE #3
RE #4
Notice that the reversing entries are the exact opposites of the adjusting entries.
Sample- Utilities:
With reversing entries No reversing entries
1/1/x3 Utilities payable
(RE #1) Utilities expense NONE
To record the reversing entry
20x3 Utilities expense Utilities payable
Cash Cash
To record the payment of unpaid To record the payment of unpaid
utilities of the previous period utilities of the previous period
Businesses customarily record disbursements for items of expense by debiting an expense account
(expense method) and collections of items of income by crediting an income account (income method).
The reversing entry simplifies the recording in the next accounting period (i.e., 20x3) by permitting the
business to record the cash payment for the utilities in the customary way (i.e., a debit to an expense
account).
If no reversing entry is made, the bookkeeper needs to go back to the records to identify the balance of
the “utilities payable” account, which is the account to be debited. This can be cumbersome when there
are many transactions to be recorded in the period.
The balances of the accounts should be equal whether or not reversing entries are made.
Session 10: Merchandising Business
Module Learning Objectives:
1. Prepare the Statement of Cost of Goods Sold and Gross Profit;

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2. Complete the accounting cycle of a merchandising business.
Welcome to this module!
Activate Prior Knowledge:

Answer the following questions:
1. List down 5 major differences you observe between the service business and merchandising business.
*Write your answer in a yellow paper.
Now, let’s acquire new knowledge!

Introduction
We have already completed the accounting cycle of a service business in the previous chapter. In
this chapter, we will complete the accounting cycle of a merchandising business. Again, a merchandising
business is one that buys and sells goods without changing their physical form. Also, we will discuss
some concepts that are applicable to merchandising business but not to a service business.
Merchandising vs. Service Companies Income Statements: An Overview
Even though merchandising companies and service companies conform to generally accepted accounting
principles (GAAP), there are differences in the ways each prepares its financial statements,
especially income statements, where most differences center around the existence of inventory.
Service entities perform services for a fee. In ascertaining profit, a basic income statement is all that is
needed, where profit is measured as the difference between revenues from services and expenses.
When you review a service income statement while simultaneously viewing a merchandising income
statement, the first difference you'll notice is that the latter carries an account called "cost of goods sold,"
while the former does not. Service-based businesses don't carry inventory and therefore don't use this
account. For a merchandising company, cost of goods sold or COGS is an expense account that refers to
the cost of purchasing the inventory and shipping it to the appropriate locations for selling to customers.
Service Merchandising
Income Statement Income Statement
Revenue from Services Net Sales
minus
Cost of Sales
minus equals
Gross profit

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add or minus
Expenses Income or Expenses
equals equals
Profit Profit
Figure 1. Components of Income Statement for Service and Merchandising Entities
MERCHANDISING BUSINESS
Net sales arise from the sale of goods while cost of sales of 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 cost (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.
A&A Trading
Income Statement
For the Year Ended Dec. 31, 2018
Net Sales 2,000,000.00
Cost Of Sales 1,200,000.00
Gross Profit 800,000.00
Operating Expenses 100,000.00
Operating Profit 700,000.00
Finance Costs 40,000.00
Profit 660,000.00
Operating Cycle of a Merchandising Business

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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. The following illustrates the operating cycle of merchandiser:
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. The more common source documents along with their
descriptions are shown next page. Also, samples of some of these source documents are to be found on
the succeeding pages.
1. Sales Invoice – 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. Bill of Lading – 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. Statement of Account – a formal notice to the debtor detailing the accounts already due.
4. 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. Deposit slips - 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. Check - 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.

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7. Purchase requisition - a written request to the purchaser of an entity from an employee or
user department of the same entity that goods be purchased.
8. Purchase order - an authorization made by the buyer to the seller to deliver the
merchandise as detailed in the form.
9. Receiving report - a document containing information about goods received from a vendor.
It formally records the quantities and description of the goods delivered.
10. Credit memorandum - 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.

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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 give 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.
Seller’s Point-of-View Buyer’s Point-of-View
Cash discounts are called SALES DISCOUNTS Cash discounts are called PURCHASE DISCOUNTS
It is usually worthwhile for the buyer to take a discount if offered although it may be necessary
to borrow the money to make the payment.
Illustration. Assume that an invoice for P50,000 with terms 3/10, n/30, is to be paid within the discount
period with money borrowed for the remaining 20 days Of the credit period. If an annual interest rate of
12 percent is assumed, the net savings to the buyer is P1,530 which is determined as follows:
Cash discount of 3% on P50,000 P 1,5000.00
Interest for 20 days at an annual rate of 12% on the amount due within the
discount period:
P 48,500* x 12% x 20/360

323.33
Savings Effected by Borrowing P 1,176.67
*Amount Due = P50,000 Invoice Price – P1,500 Cash discounts
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.

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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 as
“n/10 eom”.
CASH DISCOUNTS
These are given to persuade prompt payment. 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 discount
period.
Seller’s point-of-view Buyer’s point-of-view
Cash discounts are called SALES DISCOUNTS Cash discounts are called PURCHASE DISCOUNTS.
It is usually worthwhile for the buyer to take a discount if offered even if it would mean borrowing the
money to make the payment.
Illustration: Assume that an invoice of P50, 000 with terms 3/10, n/30, is to be paid within the discount
period with money borrowed for the remaining 20 days of the credit period. If an annual interest rate of
12% percent is assumed, the net savings to the buyer is P
Cash discount of 3% on P50, 000 P1, 500.00
Interest for 20 days at an annual rate of 12% on the

amount due within the discount period:
P48, 500* X 12% X 20/360 323.33
Savings effected by borrowing P 1, 176.67
TRADE DISCOUNTS
A trade discount is the amount by which a manufacturer reduces the retail price of a product when it sells
to a reseller, rather than to the end customer. It encourage the buyers to purchase products because of
markdowns from the list price. Trade discounts should not be confused with cash discounts
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.

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For example, ABC International offers its resellers a trade discount. The retail price for a book is P400.
One reseller orders 500 books, for which ABC grants a 30% trade discount. Thus, the total retail price of
P200, 000 is reduced to P140, 000, which is the amount that ABC bills to the reseller. The trade discount
is therefore P60, 000.
List price (P400 x 500) P200, 000

Less: 30% trade discount 60, 000
Invoice price P 140, 000
Trade discounts may be stated in a series. Assume instead that the trade discount given by the book
shop to the buyer is 30% and 10%, the invoice price will be:
List price (P400 x 500) P200, 000

Balance 140, 000
Invoice price P 126, 000
In the first example, both the buyer and the seller would record only the P140,000 invoice
price while in the second example, the invoice price will be P126,000.
Transportation Costs
When merchandise is shipped by a common carrier—a trucking company 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. F.O.B. 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 company 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.

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Sometimes, as a matter of convenience, the firm not bearing the freight cost pays the
carrier. When this situation occurs, the seller and buyer simply adjust the amount of the
payment for the merchandise. Figure 7-3 shows which party—the buyer or the seller—shoulders the
transportation costs and pays the shipper for various freight terms:
Freight Terms Who shoulders the TC? Who pays the shipper?
FOB Destination, Freight Prepaid Seller Seller
FOB Shipping Point, Freight Collect Buyer Buyer
FOB Destination, Freight Collect Seller Buyer
FOB Shipping Point, Freight Prepaid Buyer Seller
Figure 2. 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 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. Refer to the appendix of
this chapter for the comparative illustrations.
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. Supermarkets and

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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-sale 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 a company 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 entries 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 its proper balance. The periodic
inventory system will be adopted in the next sections.
To illustrate the major parts of the merchandising income statement selected transactions
made by A&A Traders will be used unless otherwise stated.
NET SALES
Net sales is the first part of the merchandising income statement as presented below:
A&A Traders
Partial Income Statement
For the Year Ended Dec. 31, 2018
Net Sales
Gross Sales P 2,463,500
Less: Sales Returns and Allowances P 27,500
Sales Discounts 42,750 70,250
Net Sales P 2,393,250
Exhibit 3 Partial Income Statement—Net Sales
Gross Sales
Under accrual accounting, revenues from the sale of merchandise are considered to be
earned in the accounting period in which the title of goods passes—usually at the point of

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delivery—from the seller to the buyer. Gross sales consist of total sales for cash and on
credit during an accounting period. Although cash for the sale is uncollected, the revenue
is recognized as earned at the time of the sale. For this reason, there is likely to be a
difference between net sales and cash collected from those sales in a given period.
As an income account, the sales account is credited whenever sales on account or cash
sales are made. Only sales of merchandise held for resale are recorded in the sales
account. If a merchandising firm sold one of its delivery trucks, the credit would be
made to the delivery equipment account, not to sales account.
The journal entry to record the sale of merchandise for cash is as follows:
Oct. 10 Cash 15,000
Sales 15,000
To record sale of merchandise for cash.
If the sale of merchandise is made on credit, the entry will be:
Oct. 10 Accounts Receivable 15,000
Sales 15,000
To record sale of merchandise on credit.
Sales Discounts
Assume that A&A Traders sold merchandise on Oct. 15 for P1,500; terms 2/10, n/30.
At the time of sale, the entry is:
Oct. 15 Accounts Receivable 1,500
Sales 1,500
To record sales on credit; terms 2/10, n/30.
The customer may take advantage of the sales discount any time on or before Oct. 25,
which is 10 days after the date of the invoice. If the client paid on Oct. 25, the entry is:
Oct. 25 Cash 1, 470
Sales Discounts 30
Accounts Receivable 1,500

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To record collection on the Sept. 20
sale, discounts taken.
At the end of the accounting period, the sales discounts account has accumulated all the
sales discounts for the period. The account is considered a contra-income account and
deducted from gross sales in the income statement (see Exhibit 3).
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 cases, the buyer may return the goods to the seller for credit if the sale was made
on account or for cash refund if the sale was for cash. Alternatively, the seller may just
grant an allowance or deduction from the selling price. A high sales returns and
allowances figure is not commendable because it may signal poor quality of goods and
thus may result to dissatisfied customers.
Each return or allowance is recorded as a debit to an account called sales returns and
allowances. An example of such transaction follows:
Oct. 12 Sales Returns and Allowances 760
Accounts Receivable (or Cash) 760
To record return or allowance on

unsatisfactory merchandise.
The seller usually issues the customer a credit memorandum, i.e., accounts receivable
or cash is credited, which is a formal acknowledgment that the seller has reduced the
amount owed by the customer. Sales returns and allowances is a contra-income account
and is accordingly deducted from gross sales in the income statement (see Exhibit 3).
Transportation Out
When the freight term is FOB destination, the seller shoulders the transportation costs;
when the term is FOB shipping point, the buyer bears the shipping costs.
Case No. 1. Assume thatA&A Traders sold merchandise totaling P7, 000 FOB
destination, freight prepaid',terms 2/10, n/30. The transportation costs amounted to
P900. The entry to record this transaction would be:
Sept. 25 Accounts Receivable 7,000
Transportation Out 900

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Sales 7,000
Cash 900
Sales on account; terms 2/10, n/30; FOB

destination, freight prepaid, P900.
If this invoice is collected on Oct. 5, the sales discount will be P140 (P7,000 x 2%).
Transportation out is an operating expense.
Oct. 5 Cash 6,860
Sales Discounts 140
Case No. 2. Assume A&A Traders sold merchandise totaling P7, 000 FOB
that
shipping point, freight collect’, terms 2/10, n/30. The transportation costs amounted to
P 900. The entry to record this transaction would be:
Nov. 25 Accounts Receivable 7,000
Sales 7,000
Sold merchandise on account; terms 2/10,

n/30; FOB shipping point, freight collect.
There is no debit to transportation out account since the shipping term provided that the
buyer should shoulder the transportation costs. If this invoice is collected on Dec. 5, the
sales discount will be P140 (P7,000 x 2%). The entry would be:
Dec. 5 Cash 6,860
Sales Discounts 140
Case No. 3. Now, that A&A Traders sold merchandise totaling P7,000 FOB
assume
destination, freight collect',
terms 2/10, n/30. The transportation costs amounted to
Transportation Out 900

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Sales 7,000

destination, freight collect, P900.
Accounts receivable is decreased by the transportation charges paid by the buyer for the
benefit of the seller. If this invoice is collected on Dec. 5, the sales discount will be P140
(P7,000 x 2%) since the discount applies to total sales.
Dec. 5 Cash 14,760
Sales Discounts 140
Case No. 4. Assume further that

A&A Traders sold merchandise totaling P7,000
FOB shipping point, freight prepaid-,
terms 2/10, n/30. The transportation costs
amounted to P900. The entry to record this transaction would be:
Sales 17,000
Cash 900

shipping point, freight prepaid, P900.
If this invoice is collected on Dec. 5, the sales discount will be P340 (P7,000 x 2%).
Dec. 5 Cash 17,760
Sales Discounts 140
The discount only applies to total sales.
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

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for sale during the year is the sum of two factors—merchandise inventory at the
beginning of the year and net purchases during the period.
If an entity is able to sell -all the goods available for sale during a given accounting
period, the cost of sales would then equal goods that had been available for sale. In most
cases, however, the business will have goods still unsold at the end of the year. To find
the actual cost of sales, the merchandise inventory at the end of the period is subtracted
from the goods available for sale.
Exhibit 4 showed goods costing P800, 000 as available for sale—A&A started with
P50,000 in beginning merchandise inventory and purchased (net) P944, 560 worth of
goods during the year. At the end of the year, P355, 000 of goods were left unsold; this
amount should appear as the merchandise inventory in the balance sheet. When this
ending merchandise inventory is subtracted from goods available for sale, the resulting
cost of sales is P639, 560.
A&A Traders
Partial Income Statement
For the Year Ended Dec. 31,2018
Cost of Sales
Merchandise Inventory, 1/1/2018 P 50,000

Purchases P 945,000
Less: Purchases Returns and Allowances P 50,800
Purchases Discounts 32,000 82,800
P 862,200
Transportation In 82,360
Net Purchases 944, 560
Goods Available for Sale 994, 560
Less: Merchandise Inventory, 12/31/2006 355, 000
Cost of Sales 639, 560
Exhibit 7-3 Partial Income Statement—Cost of sales
*Amounts are assume and given.
In summary, goods available for sale during a period come from beginning inventory and net purchases.
The goods are either sold during the period or remain unsold at the end of the period. Goods available
for sale will eventually turn to expense for the period—as cost of sales or to
asset—as merchandise inventory.
To understand fully the concept of cost of sales, it is necessary to examine the details
affecting merchandise inventory and net purchases.
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

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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 7-3, beginning
and ending inventories 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 Purchases
Under the periodic inventory method, net purchases consist of gross purchases minus
purchases discounts and purchases returns and allowances; plus transportation costs.
Purchases
When the periodic inventory method is used, all purchases of merchandise are debited to
the purchases account as shown below:
Nov. 12 Purchases 30,000
Accounts Payable 30,000
To record purchases of merchandise;
terms 2/10, n/30.
The purchases account, a temporary account, is used only for merchandise purchased for
resale. Its sole purpose is to accumulate the total cost of merchandise purchased during
an accounting period. Purchases of other assets such as equipment should be recorded in
the appropriate asset 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. This should be recorded as follows:
Nov. 14 Accounts Payable 2,000
Purchases Returns and Allowances 2,000
Return of damaged merchandise
purchased on Nov. 12.
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

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invested in the goods. There may also be lost sales resulting from poor ordering or
unsaleable goods. Frequent returns may call for new purchasing procedures or suppliers.
Purchases Discounts
Merchandise purchases are usually made on credit and commonly involve purchases
discounts for early payment. In relation to the Nov. 12 and 14 transactions, the payment
is recorded as follows:
Nov. 22 Accounts Payable 13,000

Purchases Discounts (P13,000 x 2%) 260
Cash 12,740
Like purchases returns and allowances, purchases discounts is a contra account that is
deducted from purchases on the income statement. If the entity makes a partial payment
on an invoice, most creditors will allow the company to take the discount applicable to
the partial payment. The discount does not apply to transportation or other charges that
might appear on the invoice.
Transportation In
Case No. 1. Assume that A&A Traders made purchases totaling P8,500 FOB
destination, freight prepaid; terms 2/10, n/30. Transportation costs amounted to P950.
The entry would be:
Purchased merchandise on account; terms
2/10, n/30; FOB destination, freight prepaid.
There is no debit to transportation in account since the shipping term provided that the
seller should shoulder the transportation costs. In addition, the seller prepaid the freight.
If this invoice is paid on Dec. 5, the purchases discount will be P170 (P8,500 x 2%). The
entry would be:
Dec. 5 Accounts Payable 8,500
Purchases Discounts 170
Cash 8,330
Case No. 2. Assume that A&A made purchases totalling P8,500 FOB shipping point,
freight collect’, terms 2/10, n/30. The transportation costs amounted to P950. The entry
to record this transaction would be:
Transportation In 950
Cash 950
Purchases on account; terms 2/10, n/30;

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FOB shipping point, freight collect, P950.
If this invoice is paid on Dec. 5, the purchases discount will be.P170 (P8,500 x 2%).
Transportation in will form part of net purchases.
Cash 8,330
Case No. 3. Now, assume that A&A Traders made purchases totaling P8,500 FOB
destination, freight collect', terms 2/10, n/30. The transportation costs amounted to 1’950.
The entry to record this transaction would be:
Cash 950
Purchases on account; terms 2/10, n/30;
FOB destination, freight collect, P950.
Accounts payable is decreased by the transportation charges paid by the buyer for the
benefit of the seller. If this invoice is paid on Dec. 5, the purchases discount will be P170
(P8,500 x 2%) because the discount applies to total purchases.
Cash 7,380
Case No. 4. Assume furtherthat A&A Traders made purchases totaling P8,500 FOB
shipping point, freight prepaid', terms 2/10, n/30. The transportation costs amounted to
Transportation In 950
Purchased merchandise on account; terms
2/10, n/30; FOB shipping point, freight
prepaid, P950.
If this invoice is paid on Dec. 5, the purchases discount will be P170 (P8,500 x 2%). The
buyer is not entitled to discounts on the transportation costs. Discounts apply only to
total purchases.
Cash 9,280
It will be useful to contrast these ‘transportation-in’ entries to the ‘transportation out’

entries.

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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.
Session 11: Partnership Formation
Partnership is an unincorporated association of two or more individuals to carry on, as co-owners, a

business, with the intention of dividing the profits among themselves.
Characteristics of a partnership
a. Ease of formation – as compared to corporations, the formation of a partnership requires less
formality.
b. Separate legal personality - personality separate and distinct from the partners. The partnership
can transact and acquire properties in its name. the partnership has a judicial
c. Mutual agency – the partners are agents of the partnership for the purpose of its business. As
such; a partner may legally bind the partnership to with the partnership's operations. A contract
or agreement that is in line
d. Co-ownership of property - each partner is a co-owner of the properties invested in the
partnership and each has an equal Fight with his partners to possess specific partnership
property Tor partnership purposes. However, a partner has no right to possess a partnership
property for any other purpose without the consent of his partners.
e. Co-ownership of profits - a partnership is created as a business
(a profit-oriented entity), as such, each partner is entitled to his share in the partnership profit. A
stipulation which excludes one or more partners from any share in the profits or losses is void.

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f. Limited life consensual. As such, a partnership may be dissolved:
i. by the express will of any partner;
ii. by the termination of a definite term stipulated in the creation of a partnership is basically
contract;
iii. by any event that makes it unlawful to carry out the partnership;
iv. when a specific thing which a partner had promised to contribute to the partnership perishes
before the delivery; or
v. expulsion, death, insolvency or civil interdiction of a partner.
g. Transfer of ownership - in case of dissolution, the transfer of ownership, whether to a new or

existing partner, requires the approval of the remaining partners.
h. Unlimited liability - each partner, including industrial ones, may be held personally liable for
partnership debt after all partnership assets have been exhausted. If a partner is
personally insolvent, his share in the partnership debt shall be assumed by the other solvent
partners.
 A partnership in which all partners are individually liable is called a general partnership.
 A partnership in which at least one partner is personally liable is called a limited
partnership. A limited partnership includes at least one general partner who maintains
unlimited liability. The others, called limited partners, may limit their liability up to the
extent of their contributions to the partnership. A limited liability partnership usually has
"LLP" in its name.
Advantages and disadvantages of a partnership
Advantage Disadvantage
Ease of formation Easily dissolved/ limited life
Shared responsibility of running the business Unlimited liability
Flexibility in decision making Conflict among partners
Greater capital compared to sole proprietorship Lesser capital compared to a corporation
Relative lack of regulation by the government as A partnership (other than a general professional
compared to corporations partnership) is taxed like a corporation
PARTNERSHIP DISTINGUISHED FROM CORPORATIONS

Manner of Creation- A partnership is created by mere agreement of the partners while a corporation is
created by operation of law.
Number of Persons- Two or more may form a partnership; in a corporation, at least five (5) persons,
not exceeding fifteen (15).
Commencement of Juridical Personality- In a partnership, juridical personality commences from the

execution of the articles of partnership; in a corporation, from the issuance of certificate of incorporation
by the Securities of Exchange Commission.

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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.
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, stockholder ls are liable only to the extent of their interest or
investment in the corporation.
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 off continued existence regardless of the death, withdrawal,
insolvency or incapacity of its directors or stockholders.
Terms of Existence- In a partnership, for any period of time stipulated by the partners; in 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.

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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

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When the partnership capital is P3, 000 or more, in money or property, the public
instrument must be recorded with the Securities 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 register 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." (Dean
Capistrano, IV Civil Code of the Philippines)
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:
 Articles of Partnership
 Verification Slip for the Business Name
 Written undertaking to change business name if required
 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:
 endorsement from other government agencies if the proposed partnership will
engage in an industry regulated1 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/filing and miscellaneous fees: filing fee equivalent to 1/5 of 1% of the
partnership capital but not less than Pl,000 and legal research fee which is 1% of the filing
fee;
 Forward documents to the SEC Commissioner for signature.
ACCREDITATION TO PRACTICE PUBLIC ACCOUNTANCY
Certified public accountants (CPAs), linns 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 Philippine Accountancy Act of 2004, Sec. 31). The rules and regulations
covering the accreditation for the practice of public accountancy are specified in Annex 8 of The Rules
and Regulations Implementing Republic Act 9298 otherwise known as the Philippine Accountancy Act of
2004.

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Accounting for partnerships
The accounting for assets and liabilities remains the same regardless of the form of a business
organization. What changes is the accounting for equity. The balance sheets of the different forms of
business organization are shown. Notice the similarities and differences.
Exhibit 1: Sole Proprietorship

WIN-WIN’s Special Barbeque
Statement of Financial Position
ASSETS
Cash and cash equivalents P 20, 000
Trade and other receivables 60, 000
Inventory 90, 000
Total current assets 170, 000
Property, plant and equipment 270, 000
Total non-current assets 270, 000
TOTAL ASSETS P 440, 000
LIABILITIES
Trade and other payables P 110, 000
Total current liabilities 110, 000
EQUITY
Ms. Win’s, Capital 330, 000
Exhibit 2: Partnership
EPG Partnership
ASSETS
Inventory 90, 000
LIABILITIES
EQUITY
Ms. E’s, Capital 110, 000
Ms. P’s, Capital 110, 000
Ms. G’s, Capital 110, 000

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Exhibit 3: Corporation
EPG Corporation
ASSETS
Inventory 90, 000
LIABILITIES
EQUITY
Share capital 110, 000
Retained earnings 270, 000
Other components of equity 60, 000
Exhibit 4: Cooperatives
EPG Multi-purpose Cooperative
ASSETS
Inventory 90, 000
LIABILITIES
EQUITY
Share capital 250, 000
Donations and grants 100, 000
Statutory funds 90, 000
Observe the following:

 The equity of a partnership is similar to the equity of a sole proprietorship except that the former is
subdivided into the partners' capital balances.

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 The equity of a corporation is similar to the equity of a cooperative, in the sense that both have
"Share capital." However, a peculiar characteristic of the equity of a cooperative is that it includes
"statutory funds." Recall from our discussion that a cooperative is required by law to appropriate a
portion of its annual profit to some funds. These funds are referred to as "statutory funds."
The following are the major considerations in the accounting for the equity of a partnership:
a) Formation partnership- accounting for initial investments to the partnership
b) Operations – division of profits or losses
c) Dissolution - admission of a new partner and withdrawal, retirement or death of a partner
d) Liquidation - winding-up of affairs
Partnership Formation
A contract of partnership is consensual. It is created by the agreement of the partners which may be
constituted in any form, such as oral or written. A partnership's legal existence begins from the moment
the contract is executed, unless otherwise stipulated.
Valuation of contributions of partners

Capital contributions of partners to the partnership are initially measured at fair value (is "the price that
would be received to sell an asset or paid to transfer a liability in an orderly transaction between market
participants at the measurement date." (PFRS 13)) When measuring the contributions of - partners, the
following additional guidance from the PFRSs shall be observed:
Type of contribution Measurement

Face amount of cash and cash equivalent
Cash and cash equivalents
contributed. (PAS 7)
Net realizable value (estimated selling price less
Inventory costs to complete and sell), if lower than cost.
(PAS 2)
Each partner's capital account is credited for the fair value of his net contribution (i.e., fair value of
contribution less any liability assumed by the partnership). No contribution shall be valued at an amount
greater than its fair value.
A partner's subsequent share in profits (losses) shall also be credited (debited) to his capital account.
Likewise, permanent withdrawals of capital are debited to the partner's capital account. Temporary
withdrawals may be debited to the partner's drawings account. The sum of the balances in the partners'
individual capital accounts represents the total equity of the partnership.
Partners' ledger accounts

The partners' ledger accounts are:
a. Capital accounts
b. Drawings accounts
c. Receivable fro/ Payable to a partner

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Capital and Drawings accounts

Each partner has his or her own capital and drawings account, e.g., "Pedro dela Cruz, Capital” and “Pedro
dela Cruz, Drawings." These accounts are equity accounts and are used to record the following
transactions:
Pedro dela Cruz, Capital

DR. Cr.
 Permanent withdrawals of capital xx xx Initial investment
 Share in losses xx xx Additional investments
 Debit balance of drawings account xx xx Share in profits
The partner’s capital account is a real account and has a normal credit balance.
Pedro dela Cruz, Drawings

DR. Cr.
 Temporary withdrawals of capital xx xx Recurring reimbursable costs paid by
during the period the partner
 Temporary funds held to be xx
remitted to the partnership
The drawings account is a nominal account that is closed to the related capital account at the end of the
period. This account is a contra equity account and has a normal debit balance.
Receivable from/Payable to a partner

The partnership may enter into a loan transaction with a partner. If a partner withdraws a substantial
amount of money with the intention of repaying it, the debit should be to Loan Receivable- Partner
account instead of the Partner’s Drawing account. This account should be classified separately from the
other receivables of the partnership. A loan extended by the partnership to a partner is recorded as a
receivable from the partner, while a loan obtained by the partnership from a partner is recorded as a
payable to the partner.
Adjustment of Accounts Prior to Formation

In case 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.
Illustration. A furniture and fixtures brought by Ms. Lady in the partnership were incorrectly recorded
in the partnership books at P90, 000, representing the book value from the proprietor’s records. If the
partnership immediately sold the furniture and fixtures for its fair market value of P 130, 000, the
resulting P 40, 000 ga in would increase the capital balances of both partners. Simply stated, increases in
asset values accruing before the formation should be for the benefit of the contributing partner.

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The adjustments of the asset and liabilities prior to formation will be similar to the adjustments we are
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 going concern.
Illustration 1:
ABA and ALB formed a general professional partnership. ABA will contribute sufficient cash to get an
equal interest in the partnership while ALB will transfer the assets and liabilities of her business. The
account balances of books of ALB prior to partnership formation follows:
Debit Credit
Cash 150, 000
Office Supplies 50, 000
Land 400, 000
Accounts Payable 355, 000
ALB, Capital 595, 000
It is agreed that for purposes of establishing ALB’s interest, the following adjustments shall be made in
the books of ALB:
1. An allowance for uncollectible accounts of 5% of accounts receivable is to be established;
2. Prepaid expenses amounting to P45, 000 were omitted by the accountant. This is to be
recognized.
3. Additional salaries payable in the amount of P20, 000 is to be established.
Using the accounting equation approach of analysis, the adjustments are as follows:
Assets = Liabilities + Owner’s Equity
1. - P 17, 500 = + - P 17, 500
2. +P 45,000 = + +P 45, 000
3. = +P 20, 000 + - P 20, 000
P27, 500 P 20, 000 P 7, 500
P27, 500 P27, 500
Entries and Explanations:

1. An allowance of 5% of P350, 000 needs to be established.
Allowance for Doubtful Accounts 17, 500
2. An omission to record the asset- prepaid expenses will denote that the expenses of the business are overstated.
Prepaid Expenses 45, 000
3. The establishment of additional salaries payable will increase liabilities. CARD-MRI Development Institute, Inc.
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Salaries Payable 20, 000
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The adjustments prior to formation will entail debits or credits to asset or liability accounts. To maintain
the double entry system of accounting, a corresponding debit or credit to owner’s equity account will be
made. The following T-account will serve to summarize the necessary adjustments to the capital account.
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.
Illustration. Aldo and Carolina agreed to form a partnership on November 1, 2020. The partnership
agreement specified that Aldo is to invest cash of P 980, 000 and Carolina is to contribute land with a fair
market value of P 2, 000, 000 with P 600, 000 mortgage to be assumed by the partnership. The entries
to record are as follows:
Owner’s Equity Account

Dr. Cr.
Cash 980, 000
Land 1. Decrease in asset. 1. Increase in asset.
2, 000, 000
2. Increase in liability
Mortgage Payable 2. Decrease
600,in000
liability.
Aldo, Capital 3. Increase in contra-assert. 3. Decrease
980,in000
contra-assets.
Carolina, Capital 1, 400, 000
To record the initial investments of Aldo
Carolina

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After the formation of partnership, the statement of financial position will be:
DoLina Partnership
November 1, 2020
ASSETS
Current Asset
Cash P 980, 000
Total Current Asset 980, 000
Non Current Asset

Land 2, 000, 000
Total Non Current Asset 2, 000, 000
TOTAL ASSETS P2, 980, 000
LIABILITIES
Mortgage Payable 600, 000
Total Liabilities P 600, 000
OWNER’S EQUITY
Aldo, Capital P 980, 000
Carolina, Capital 1, 400, 000
Total Owner’s Equity P2, 380, 000
TOTAL LIABILITIES AND OWNER’S EQUITY P2, 980, 000
Suppose that Aldo and Carolina formed partnership with Maxim- an industrial partner. The partnership
did not receive any asset from Maxim. In this case, only a memorandum entry in the general journal will
be made.
A Sole Proprietor and an Individual without an Existing Business 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 proprietorship will be transferred to the
newly formed partnership at values agreed upon by all the partners or at their current fair prices.
Illustration. Supposed that Aldo already have an existing business and agreed to form a partnership with
Carolina who has no existing business. The statement of financial position of Aldo on November 1, 2020,
before accepting Carolina as partner is shown as follows:

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Aldo’s Shoe Lab

November 1, 2020
ASSETS
Cash P 980, 000
Notes Receivable 30, 000
Accounts Receivable P 240, 000
Less: Allowance for Uncollectible Accounts 10, 000 230, 000
Merchandise Inventory 80, 000
LIABILITIES
Accounts Payable P 340, 000
OWNER’S EQUITY
Total Owner’s Equity P 980, 000
Carolina offered to invest cash to get a capital equal to one-half of Aldo’s capital after giving effect to the
adjustments below.
a. The merchandise is to be valued at P70, 000.
b. The accounts receivable is estimated to be 94% collectible.
c. Office supplies on hand that have been charged to expense in the past amounted to P10, 000. These
will be used by the partnership.
New books for the Partnership

The following procedures may be used in recording the formation of the partnership:
Books of Aldo:
a. Adjust the assets and liabilities of Aldo in accordance with the agreement. Adjustments are to be made
to his capital account.
b. Close the books.
Books of the Partnership:

a. Record the investment of Aldo.
b. Record the investment of Carolina.
Following the procedures, the entries are:

Books of Aldo (1)

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Office Supplies P 10, 000
Allowance for Uncollectible Accounts 4, 400
To record adjustments to restate
Aldo’s capital
(2)
Accounts payable P 340, 000
Aldo, Capital 975, 600
Cash 980, 000
To close the books of Aldo
Books of the Partnership (1)
Cash 980, 000

Office Supplies P 10, 000
To record the investment of Aldo
(2)
Cash P 487, 800
Carolina, Capital P 487, 800
To record the investment of Carolina

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Computations:
1. Merchandise Inventory, per ledger P80, 000
Merchandise Inventory, as agreed 70, 000
Decrease in Merchandise Inventory P10, 000
2. Accounts Receivable, net per ledger P230, 000

Accounts Receivable, net as agreed 225, 600
Increase in Allowance P 4,400
3. Net effect of adjustments on Capital:

Decrease in Merchandise Inventory P (10, 000)
Increase in Allowance for Uncollectible ( 4, 400)
Increase in Office Supplies 10, 000
Decrease in Aldo, Capital P (4, 400)
4. Aldo, Capital before adjustment P980, 000

Net adjustments to Capital 4, 400
Aldo, Capital after adjustment P975, 600
Agreed Capital credit for Carolina 50%
Cash investment of Carolina P487, 800
After the formation, the statement of financial position of the newly formed partnership is:
DoLina Partnership
November 1, 2020
ASSETS
Cash P1, 467, 800
LIABILITIES
OWNER’S EQUITY
Carolina, Capital 487, 800

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The accounts receivable is still recorded at gross amount of P240, 000 with a related allowance for
uncollectible accounts of P14, 400. The P 14, 400 is only a provision for possible uncollectibles.
Two or More Sole Proprietors Form a Partnership
Supposed that Aldo and Carolina are both proprietors and agreed to form a partnership, bringing their
individual sole proprietorships’ assets and liabilities into the partnership. Their statements of financial
position are shown as follows:
Carol’s Tie the Laces Aldo’s Shoe Lab

Statement of Financial Position Statement of Financial Position
November 1, 2020 November 1, 2020
ASSETS ASSETS
Cash P 487, 800 Cash P 980, 000
Accounts Receivable 70, 000 Notes Receivable 30, 000
Merchandise Inventory 85, 000 Accounts Receivable P 240, 000
TOTAL ASSETS P 642, 800 Less: Allowance for Uncollectible Accounts 10, 000 230, 000
LIABILITIES TOTAL ASSETS P1, 320, 000
Total Liabilities P 250, 000 LIABILITIES
OWNER’S EQUITY Total Liabilities P 340, 000
Carolina, Capital P 392, 800
Total Owner’s Equity P 392, 800 OWNER’S EQUITY
TOTAL LIABILITIES AND OWNER’S EQUITY P 642, 800 Total Owner’s Equity P 980, 000
The conditions and adjustments agreed upon by the partners for purposes of determining their interests
in the partnership are
1. Only 90% of Accounts Receivable are collectible in each book.

2. The merchandise inventory of Carolina is to be increased by P13, 500.
3. Actual count and bank reconciliation on Aldo proprietorship’s cash account revealed cash short of P 2,
800.
4. Office supplies on hand that have been charged to expense in the book of Aldo in the past amounted
to P10, 000. These will be used by the partnership.
New books for the Partnership

The following procedures may be used in recording the formation of the partnership:
Books of Aldo and Carolina:

a. Adjust the accounts of both parties in accordance with the agreement. Adjustments are to be made to
their respective capital accounts.

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b. Close the books.
Books of the Partnership:

a. Record the investment of Aldo.
b. Record the investment of Carolina.
Following the procedures, the entries are:

Books of Aldo (1)

Cash 2, 800
Office supplies 10, 000
Aldo’s capital
(2)
Accounts payable P340, 000
Cash 982, 800
To close the books of Aldo
Books of Carolina (1)
Merchandise Inventory P 13, 500

Carolina’s capital
(2)
Cash 487, 800
To close the books of Carolina
Books of the Partnership (1)
Cash 982, 800

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To record the investment of Aldo
(2)
Cash P 487, 800
To record the investment of Carolina
After the formation, the statement of financial position of the newly formed partnership is:
DoLina Partnership
November 1, 2020
ASSETS
Cash P1,470, 600
LIABILITIES
OWNER’S EQUITY

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Bonus on initial investments
An accounting problem exists when a partner’s capital account is credited for an amount greater than the
fair value of his contribution.
For instance, a partnership agreement may allow a certain partner who is bringing in expertise or special
skill to the partnership to have a capital credit greater than the fair value of his contributions. In such
case, the additional credit to the partner’s capital (i.e., the ‘bonus’) is accounted for as a deduction from
the capital of the other partners. This accounting method is called the “bonus” method.
Although, the credit to the partner’s capital may vary due to a ‘bonus’, the corresponding debit to the
asset account must still be equal to the fair value of the contribution. The difference between the
amounts credited and debited is treated as adjustment to the capital accounts of the other partners.
Illustration 1: Bonus method
F and G agreed to formed a partnership. F contributed P40, 000 cash while G contributed equipment with
fair value of P100, 000. However, due to the expertise that F will be bringing to the partnership, the
partners agreed that they should initially have an equal interest in the partnership capital.
Solution:
Additional contributions Bonus method

F 40, 000 (140, 000 x 50%) 70, 000
G 100, 000 (140, 000 x 50%) 70, 000
Total 140, 000 140, 000
Cash 40, 000

Equipment 100, 000
F, Capital (40, 000 + 30, 000 bonus) 70, 000
G, Capital (100, 000 - 30, 000 bonus) 70, 000
Notes:
- The bonus given to F, i.e., P30, 000 (P70, 000 capital credit- P40, 000 actual contribution) is treated as
a reduction to the capital credit of B.
- After applying the bonus method, the total capital; of the partnership is still equal to the fair value of
the partners’ contributions. The debits to “Cash” and “Equipment” are equal to their fair values. Only the
amounts credited to the partner’s capital accounts have varied.
Variations to the Bonus Method
A partnership agreement may stipulate a certain ratio to be maintained by the partners representing their
specific interests in the equity of the partnership. This stipulation may give rise to adjustments to the
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any increase or decrease to the capital credit of a partner is not deducted from his co-partners’ capital
accounts. Instead, the capital adjustment is accounted for as either:
a. Cash settlement among the partners; or

b. Additional investment or withdrawal of investment of a partner.
The following illustrations are variations to the bonus method:
Illustration 1: Cash settlement between partners

F, G and H formed a partnership. Their contributions are as follows:
F G H
Cash 40, 000 10, 000 100, 000
Equipment 80, 000
Totals 40, 000 90, 000 100, 000
-The equipment has an unpaid mortgage of P20, 000, which the partnership assumes to repay.
-The partners agreed to equalize their interests. Cash settlements among the partners are to be made
outside the partnership.
Requirements:
a. Which partner(s) shall receive cash payment from the other partner(s)?
b. provide the entry to record the contributions of the partners.
Solutions:
Requirement (a):
F G H Partnership
Cash 40, 000 10, 000 100, 000 150, 000
Equipment 80, 000 80, 000
Mortgage payable (20, 000) (20, 000)
Net contribution 40, 000 70, 000 100, 000 210, 000
Equal interest (210 / 70, 000 70, 000 70, 000 210, 000
3)
Cash receipt (30, 000) - 30, 000
(payment)
Answer: H shall receive P30, 000 from F. Cash 150, 000

Requirement (b): Equipment 80, 000
Mortgage Payable 20, 000
F, Capital 70, 000
G, Capital 70, 000
H, Capital 70, 000
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Notes:
- The cash settlement among the partners is not recorded in the partnership’s books because this is not a
transaction of the partnership but rather a transaction among the partners themselves.
- The partnership’s capital of P210, 000 remains the same after the cash settlement. Again, what varied
are only the credits to the partner’s capital accounts.
Illustration 2: Additional investment (Withdrawal of investment)

F and G agreed to form a partnership. The partnership agreement stipulates the following:
- Initial capital of P 140, 000.
- A 60:40 interest in the equity of the partnership.
F contributed P100, 000 cash, while G contributed P40, 000 cash.
Requirement: Which partners should provide additional investment (or withdraw part of his investment)
in order to bring the partners’ capital credits equal to their respective interests in the equity of the
partnership?
Solution:
Agreed initial capital P140, 000
F’s require capital balance (140, 000x 60%) 84, 000
G’s require capital balance (140, 000x 40%) 56, 000
F G Total
Actual contributions 100, 000 40, 000 140, 000
Required capital balance 84, 000 56, 000 140, 000
Additional (Withdrawal) (16, 000) 16, 000 -
Answer: F shall withdraw P16, 000 from his initial contribution, while G shall make an additional
investment of P16, 000
Ready for the drill? Let’s have an application activity!

Now, give yourself two big thumbs up for your effort!!!
Application 1-a
PROBLEM 1- Completing the cycle.
Requirements:
a. Provide journal entries.
b. Post the entries to the ledger.

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c. Prepare the unadjusted trial balance.
d. Provide the adjusting entries.
e. Complete the worksheet up to post-closing trial balance.
f. Prepare the closing entries.
g. Prepare the balance sheet and income statement.
Entity Backspace started operations in 20x1. The following were the transactions for the year ended
December 31, 20x1:
1. The owner invested P 300, 000 cash in the business.

2. The business obtained a 12%, one-year, bank loan of P200, 000 on October 1, 20x1. Principal and
interest are due at maturity date.
3. Purchased office supplies worth P80, 000 for cash (Entity Backspace uses the Asset method).
4. Purchased equipment on November 1, 20x1 for P360, 000 cash. (5 years useful life)
5. Rendered services worth P180, 000 for cash.
6. Rendered services worth P420, 000 on account.
7. Collected P370, 000 accounts receivable.
8. Paid utilities expense of P16, 000.
9. Paid salaries expense of P140, 000.
10. The owner withdrew P100, 000 cash from the business.
Application b
Instruction: For each of the sales terms, determine the following:
1. the amount recorded as a sale.
2. the amount of cash received.
On July 1, 2019, Savery Lace & Boxes sold merchandise with a P 150, 000 list price.
Trade Discount Credit Terms Date Paid

a. 30% 2/10, n/30 July 8
b. 40% 1/10, n/30 July 15
c. - 2/10,n/30 July 11
d. 20% 1/15,n/30 July 14
e. 40% n/30 July 28
Application C
1. On January 1, 20x1, Mr. A and Ms. B formed a partnership. Mr. A contributed cash of ₱500,000
while Ms. B contributed a building with carrying amount of ₱400,000 and fair value of ₱800,000. The
building has an unpaid mortgage of ₱200,000 which is not assumed by the partnership.
Requirement: Provide the journal entry to record the contributions of the partners.

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2. A and B formed a partnership. The following are their contributions:
A B
Cash 500,000 -
Accounts receivable 100,000 -
Building 700,000
Total 600,000 700,000
A, capital 600,000
B, capital 700,000
Total 600,000 700,000
 The accounts receivable includes a ₱20,000 account that is deemed uncollectible.
 The building is over-depreciated by ₱50,000.
 The building has an unpaid mortgage ₱100,000, which is assumed by the partnership.
Requirement: Provide the journal entry to record the contributions of the partners in the partnership
books.
3. A and B agreed to form a partnership. A contributed ₱40,000 cash while B contributed equipment
with fair value of ₱100,000. However due to the expertise that A will be bringing to the partnership, the
partners agreed that they should initially have an equal interest in the partnership capital.
Requirement: Provide the journal entry to record the initial investments of the partners.
Assessment 1-a: (Write your answer in a separate paper.)

Requirement:
Prepare the worksheet on December 31, 20x1.
Entity Y started operations on December 31, 20x1. The following were the transactions during the month:
1. The owner invested P320, 000 cash to the business.
2. Obtained a 10%, one-year, bank loan for P200, 000 on December 1, 20x1. Principal and interest are
due at maturity date.
3. Acquired equipment for P240, 000 cash on December 1, 20x1.
4. Paid six months’ rent in advance of P108, 000 covering the months of December 20x1 to May 20x2.
(Use the asset method).
5. Rendered services worth P260, 000 for cash during the period.
6. Paid billings for utilities used amounting to P15, 000.
7. The owner withdrew a total of P50, 000 cash from the business during the period.
-Unpaid salaries amounted to P8, 000.

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-The equipment has a useful life of 4 years.
Assessment b: (Write your answer in a separate paper.) Replace the lettered blanks with the
appropriate amounts.
The partial income statements of five different companies are as follows:
A B C D E
Net Sales A. D. 250, 000 290, 000 400, 000
Merchandise B. 50, 000 70, 000 J. 120, 000
Inv., 1/1/2019
Net purchases 80, 000 E. G. 160, 000 390, 000
Goods 110, 000 160, 000 H. K. M.
available for
Sale
Merch. Inv., 40, 000 F. 30, 000 70, 000 N.
1/31/2019
Cost of Goods C. 140, 000 230, 000 L. 380, 000
Sold
Gross Profit 50, 000 40, 000 I. 160, 000 O.
Timeline!
Let’s be mindful to your deadline.
Activity Name of Activity Date of submission Remarks
Number
1 Application: a,b, and c Next module delivery
2 Assessment: a and b Next module delivery
References
1. Basic Accounting Made Easy – Win Ballada 2020 Edition, Dynasty BookSource Asia (DBA)
2. Fundamentals of Accounting (User-Friendly)- Omar Erasmo G. Ampongan
3. Fundamentals of Accounting- Dr. William Baltazar
4. Fundamentals of Accountancy, Business and Management 1- Rabu, Tugas, Salendrez
5. Financial Accounting and Reporting (fundamentals)- Zeus Vernon B. Millan

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Financial Accounting and Reporting I

Module Content || Week 9 to 14

Module Learning Objectives:

Welcome to this module!

Activate Prior Knowledge:

Now, let’s acquire new knowledge!

CARD-MRI Development Institute, Inc.

The transactions are recorded in the journal as follows:

(1) Cash P 50, 000

(2) Cash P 50, 000

Using the ASSET METHOD:

Using the EXPENSE METHOD:

(4) Equipment P 30, 000

Using the ASSET METHOD:

Using the EXPENSE METHOD:

CARD-MRI Development Institute, Inc.

For single entry:

(6) Cash P 60, 000

Accounts receivable P 18, 000

For compound entry:

(7) Watson, Drawings P 25, 000

CASH ACCOUNTS RECEIVABLE

CARD-MRI Development Institute, Inc.

WATSON, CAPITAL WATSON, DRAWING

SERVICE REVENUE SUPPLIES EXPENSE

STEP 4: UNADJUSTED TRIAL BALANCE

The unadjusted trial balance on December 31, 20x2 is prepared as follows:

STEP 5: ADJUSTING ENTRIES

CARD-MRI Development Institute, Inc.

1. Accruals of income and expense

2. Recognition of depreciation expense and bad debts expense

3. Deferrals of income and expenses (splitting the mixed accounts).

 Teckson Repair Shop has note payable.

 Of the total supplies purchased during the

From our analyses, we have identified adjustments for the following:

Let’s start taking up the adjustments:

Dec. 31, 20x2 Utilities expense 2, 800

CARD-MRI Development Institute, Inc.

AJE #2: Interest expense

Dec. 31, 20x2 Interest expense 416.67

AJE #3: Depreciation Expense

Annual depreciation P 6, 000

Shortcut: (P30, 000 x 1/5 x 1/12) = P 500

Dec. 31, 20x2 Depreciation expense 500

Equipment P 30, 000

AJE #4: Rent Expense

CARD-MRI Development Institute, Inc.

Dec. 31, 20x2 Prepaid Rent 15, 000

AJE #5: Supplies expense

Dec. 31, 20x2 Prepaid supplies 12, 900

Step 6: Adjusted Trial Balance

CARD-MRI Development Institute, Inc.

Notes: Worksheet Preparation

To combine the amounts, observe the rules of debits and credits:

P 20, 000 in the unadjusted trial balance minus

Prepaid supplies 12, 900 12, 900

Step 7: Preparing Financial Statements

In this modules, we will only prepare the following financial statements:

Illustration: Let us prepare the financial statement of Teckson Repair Shop.

Thus, in the income statement columns of the worksheet:

Thus, in the balance sheet columns of the worksheet:

Step 8: Closing the books

What is closing entries?