Basic Accounting 1

Introduction to Accounting
Defining “Accounting”
● The Accounting Standards Council defines accounting as a service activity. Its
function is to provide quantitative information, primarily financial in nature, about
economic entities that are intended to be useful in making economic decisions.
● The American Institute of Certified Public Accountants (AICPA) defines accounting

as the art of recording, classifying, and summarizing in a significant manner and terms
of money, transactions, and events that are in part at least of a financial character and
interpreting the results thereof.
● The American Accounting Association defines accounting as the process of

identifying, measuring, and communicating economic information to permit informed
judgment and decision by users of the information.
ACG001 Lecture & Textbook Notes

The textbook definition of accounting is defined as consisting of three basic activities—it
identifies, records, and communicates the economic events of an organization to interested
users.
1. IDENTIFYING: As a starting point to the accounting process, an economic entity

identifies the events relevant to its business. Identifying is the analytical component of
accounting, as it can classify the recognition or non-recognition of business activities as
“Accountable Events” or “Non-Accountable Events.”
An event can be recognized as an accountable event if: (1) it can be assigned an

amount and (2) if it affects the three basic elements of the accounting equation: assets,
liabilities, and capital. If it does affect the three elements, it is called an economic
activity. There are two types of economic activity:
a. External/Exchange Transaction - involves economic events between the

company and some outside enterprise.
b. Internal Transaction - are economic events that occur entirely within one
company.
2. MEASURING/RECORDING: Once those events have been identified, it would record

those events to prove a history of its financial activities. Recording consists of keeping a
systematic, chronological diary of events, measured in monetary units (Pesos, Dollars,
etc.)
Recording is the technical component of accounting, it is the bookkeeping, and

assigning monetary value to an accountable event. There must be a common financial
denominator. Examples are historical cost, current replacement cost, net realizable
value, or present or discounted value.
Bookkeeping usually involves only the recording of economic events. It is therefore just
one part of the accounting process. In total, accounting involves the entire process of
identifying, recording, and communicating economic events.
To make the reported financial information meaningful, the data is recorded in a

standardized way. It accumulates all sales transactions over a certain period of time and
reports the data as one amount in the company’s financial statements, which are
reported in the aggregate.

3. COMMUNICATING: The recorded data is then communicated to the interested users
through accounting reports. The main and most common form of these reports is called
financial statements, also known as FS. This is the formal component of accounting, as
it is the process of preparing and distributing accounting reports (financial statements)
to potential users of accounting information. Implicit in the communication process are:
a. Recording/Journalizing - systematically maintaining a record of all economic

transactions.
b. Classifying - sorting/grouping of similar and interrelated economic transactions

into classes.
c. Summarizing - preparing of FS (financial statements.)
Users of Accounting Data

The information that a user of financial information needs depends upon the kinds of decisions
the user makes. There are two broad groups of users of financial information: internal users and
external users.
1. External users - typically those outside of the company who need financial data for
their uses (e.g. shareholders, investors, government, etc.) They are individuals and
organizations outside a company who want financial information about the company.
The two most common types of these users are:
a. Investors (owners) use accounting information to make decisions to buy, hold,

or sell ownership shares of a company.
b. Creditors (e.g. suppliers and bankers) use accounting information to evaluate

the risks of granting credit or lending money.
2. Internal users - users who are inside the company (managers, employees, owners,
etc.) Internal users of accounting information are managers who plan, organize, and run
the business. These include marketing managers, production supervisors, finance
directors, and company officers.
● Managerial accounting provides internal reports to help users make decisions about
their companies.
● Financial accounting provides economic and financial information for investors,

creditors, and other external users.

Accounting Principles
The accounting profession has developed standards that are generally accepted and
universally practiced. This common set of standards is called generally accepted accounting
principles (GAAP). These standards indicate how to report economic events.
The Philippines uses the International Financial Reporting Standards (IFRS) as its source of
accounting standards, translated and called as the Philippine Financial Reporting Standards
(PFRS). The IFRS are created by the International Accounting Standards Board (lASB). The
Philippine counterpart of the IASB is the Financial Reporting Standards Council (ERSC). The
IFRS can be classified into two main types of standards:
1. The International Accounting Standards (IAS) - the first batch of accounting

standards promulgated before 2003. The IAS was originally created by the International
Accounting Standards Committee (IASC).
2. The International Financial Reporting Standards (IFRS) - a new set of standards

promulgated on and after 2003, by the IASB. In the Philippines, PFRSS and Philippine
Accounting Standards (PASS) are also used. Interpretations by the Philippine
Interpretations Committee can also be considered standards.
As markets become more global, it is often desirable to compare the results of companies from
different countries that report using different accounting standards. To increase comparability,
in recent years the two standard-setting bodies have made efforts to reduce the differences
between GAAP and IFRS. This process is referred to as convergence.
The GAAP generally uses one of two measurement principles, the cost principle or the fair
value principle. Selection of which principle to follow generally relates to trade-offs between
relevance and faithful representation. Relevance means that financial information is capable of
making a difference in a decision. Faithful representation means that the numbers and
descriptions match what existed or happened—if factual.
● The cost principle (or historical cost principle) dictates that companies record assets
at their cost. This is true not only at the time the asset is purchased but also over the
time the asset is held.
● The fair value principle states that assets and liabilities should be reported at fair value
(the price received to sell an asset or settle a liability). Fair value information may be
more useful than the historical cost for certain types of assets and liabilities.
Underlying Assumptions in Accounting

Also known as "Accounting Postulates,” they are the basic notions of fundamental premises
on which the accounting process is based. Assumptions provide a foundation for the
accounting process.
I. Entity (Business Entity Principle)
The entity is separate from the owners, managers, and employees who constitute the
company. The economic entity assumption requires that the activities of the entity be kept
separate and distinct from the activities of its owner and all other economic entities. An
economic entity can be any organization or unit in society.
1. Sole proprietorship - A business owned by one person. The owner is often the
manager/operator of the business. Small service-type businesses and small retail stores
are often proprietorships. Usually, only a relatively small amount of money (capital) is
necessary to start in business as a proprietorship.
2. Partnership - A business owned by two or more persons associated as partners. In

most respects, a partnership is like a proprietorship except that more than one owner is
involved. Each partner generally has unlimited personal liability for the debts of the
partnership.
3. Corporation - A business organized as a separate legal entity under state corporation

law and having ownership divided into transferable shares of stock. The holders of the
shares (stockholders) enjoy limited liability; that is, they are not personally liable for the
debts of the corporate entity.
II. Periodicity Concept
Periodicity Concept - This principle requires entities to present financial information into
functional periods, which are called accounting periods. This means that financial statements
should be presented through specific periods, such as monthly, quarterly, annually, or even
weekly.
This requires the company to have a profit and loss account and a balance sheet prepared at
regular intervals to identify all the shortcomings in performance evaluation, tax calculations,
budget control, etc. Determining the income of a period leads to a comparison of the results of
subsequent periods. The periodicity concept is specific to a business type and some types of
business are called “continuing profit-seeking enterprises”.
III. Monetary Unit
The monetary unit assumption requires that companies include in the accounting records

only transaction data that can be expressed in money terms. This assumption enables
accounting to quantify (measure) economic events. The monetary unit assumption is vital to
apply the cost principle.
Quantifiability - transactions and events that can be objectively measured or quantified in

terms of the Philippine Peso.
The Accounting Equation

The accounting equation is a basic rule in accounting that justifies the existence of a
business's assets. Two basic elements of a business are what it owns and what it owes.
ASSETS = LIABILITIES + OWNER’S EQUITY
● Resources a ● Claims against total ● Ownership claim on

business owns assets (debts and total assets
obligations)
● Provide future ● Referred to as
services or ● Creditors (party to residual equity
benefits whom the money is
owed)
This relationship is the basic accounting equation. Assets must equal the sum of liabilities and
owner’s equity. Liabilities appear before the owner’s equity in the basic accounting equation
because they are paid first if a business is liquidated.
Assets are resources a business owns. The business uses its assets in carrying out such
activities as production and sales. The common characteristic possessed by all assets is the
capacity to provide future services or benefits. In a business, that service potential or future
economic benefit eventually results in cash inflows (receipts).
Liabilities are claims against assets—that is, existing debts and obligations. Businesses of all
sizes usually borrow money and purchase merchandise on credit. These economic activities
result in payables of various sorts:
● Accounts payable (AP) are defined as the company's short-term obligations owed to
its creditors or suppliers, which have not yet been paid. Payables appear on a
company's balance sheet as a current liability. Not to be confused with “trade
payables” which constitutes the money a company owes its vendors for

inventory-related goods, such as business supplies or materials that are part of the
inventory.
● A note payable is a written promissory note. Under this agreement, a borrower obtains
a specific amount of money from a lender and promises to pay it back with interest over
a predetermined time period.
● Salaries and wages payable refer to the liability incurred by an organization for wages
earned by but not yet paid to employees. When a business pays its employees salaries
as of the end of a reporting period, there is no wages payable liability, since salary
payments match the amount earned by employees through the payment date.
● Taxes payable refer to one or more liability accounts that contain the current balance of
taxes owed to government entities. Once these taxes are paid, they are removed from
the taxes payable account with a debit.
Owner’s equity is the ownership claim on total assets. It is equal to total assets minus total
liabilities. Here is why: The assets of a business are claimed by either creditors or owners. To
find out what belongs to owners, we subtract the creditors’ claims (the liabilities) from assets.
The remainder is the owner’s claim on the assets—the owner’s equity. Since the claims of
creditors must be paid before ownership claims, owner’s equity is often referred to as residual
equity.
● INCREASES IN OWNER’S EQUITY: In a proprietorship, owner’s investments and

revenues increase owner’s equity.
○ Investments by the owner are the assets the owner puts into the business.
These investments increase the owner's equity. They are recorded in a category
called owner’s capital.
○ Revenues are the gross increase in owner’s equity resulting from business
activities entered into to earn income. Generally, revenues result from selling
merchandise, performing services, renting property, and lending money.
Common sources of revenue are sales, fees, services, commissions, interest,
dividends, royalties, and rent.
● DECREASES IN OWNER’S EQUITY: In a proprietorship, owner’s drawings and

expenses decrease owner’s equity.
○ Drawings. An owner may withdraw cash or other assets for personal use. We
use a separate classification called drawings to determine the total withdrawals

for each accounting period. Drawings decrease the owner's equity. They are
recorded in a category called owner’s drawings.
○ Expenses are the cost of assets consumed or services used in the process of
earning revenue. They are the decreases in owner’s equity that result from
operating the business.
In summary, owner’s equity is increased by an owner’s investments and revenues from

business operations. Owner’s equity is decreased by an owner’s withdrawals of assets and by
expenses. The following expands the basic accounting equation by showing the accounts that
comprise the owner’s equity. This format is referred to as the expanded accounting equation.
The Expanded Accounting Equation

The accounting equation can be extended to consider the income and expenses of an entity,
aka the entity's performance. Observe that the equality of the accounting equation has been
maintained. Note that the investments by the owner do not represent revenues, and they are
excluded in determining net income.
Therefore it is necessary to make clear that the increase is an investment (increasing Owner's
Capital) rather than revenue. The following expands the basic accounting equation by showing
the accounts that comprise owner’s equity.
+ REVENUES - EXPENSES
ASSETS = LIABILITIES + OWNER’S EQUITY
NET INCOME / (NET LOSS)
Transaction Analysis
The following examples are business transactions for a computer programming business
during its first month of operations.
Transaction (1). Investment by Owner. Ray Neal decides to open a computer programming
service which he names Softbyte. On September 1, 2012, he invested $15,000 cash in the
business. This transaction results in an equal increase in assets and owner’s equity.
Observe that the equality

of the accounting equation
has been maintained. Note
that the investments by the
owner do not represent
revenues, and they are

excluded in determining net income. Therefore it is necessary to make clear that the increase is
an investment (increasing Owner's Capital) rather than revenue.
Transaction (2). Purchase of Equipment for Cash. Softbyte purchases computer equipment
for $7,000 cash. This transaction results in an equal increase and decrease in total assets,
though the composition of assets changes. Cash decreases by $7,000, and the asset
Equipment increases by $7,000. The specific effect of this transaction and the cumulative
effect of the first two transactions are:
Observe that total

assets are still
$15,000. Neal’s
equity also remains
at $15,000, the
amount of his
original investment.
Transaction (3). Purchase of Supplies on Credit. Softbyte purchases for $1,600 from Acme
Supply Company computer paper and other supplies are expected to last several months.
Acme agrees to allow Softbyte to pay this bill in October. This transaction is a purchase on
account (a credit purchase). Assets increase because of the expected future benefits of using
the paper and supplies, and liabilities increase by the amount due Acme Company.
Total assets are now $16,600. This total is matched by a $1,600 creditor’s claim and a $15,000
ownership claim.

Transaction (4). Services Provided for Cash. Softbyte receives $1,200 cash from customers
for programming services it has provided. This transaction represents Softbyte’s principal
revenue-producing activity. Recall that revenue increases owner’s equity.
The two sides of the equation balance at $17,800. Service Revenue is included in determining
Softbyte’s net income. Note that we do not have room to give details for each individual
revenue and expense account in this illustration. Thus, revenues (and expenses when we get to
them) are summarized under one column heading for Revenues and one for Expenses.
However, it is important to keep track of the category (account) titles affected (e.g., Service
Revenue) as they will be needed when we prepare financial statements later in the chapter.
Transaction (5). Purchase of Advertising on Credit. Softbyte receives a bill for $250 from the
Daily News for advertising but postpones payment until a later date. This transaction results in
an increase in liabilities and a decrease in owner’s equity. The specific categories involved are
Accounts Payable and expenses (specifically, Advertising Expense). The effect on the equation
is:
The two sides of the equation still balance at $17,800. Owner’s equity decreases when
Softbyte incurs the expense. Expenses are not always paid in cash at the time they are

incurred. When Softbyte pays at a later date, the Liability Accounts Payable will decrease, and
the asset Cash will decrease [see Transaction (8)]. The cost of advertising is an expense (rather
than an asset) because the company has used the benefits. Advertising Expense is included in
determining net income.
Transaction (6). Services Provided for Cash and Credit. Softbyte provides $3,500 of
programming services for customers. The company receives cash of $1,500 from customers,
and it bills the balance of $2,000 on account. This transaction results in an equal increase in
assets and owner’s equity.
Softbyte earns revenues when it provides the service, and therefore it recognizes $3,500 in
revenue. In exchange for this service, it received $1,500 in Cash and Accounts Receivable of
$2,000. This Accounts Receivable represents customers’ promise to pay $2,000 to Softbyte in
the future. When it later receives collections on account, Softbyte will increase Cash and will
decrease Accounts Receivable [see Transaction (9)].
Transaction (7). Payment of Expenses. Softbyte pays the following expenses in cash for
September: store rent $600, salaries and wages of employees $900, and utilities $200. These
payments result in an equal decrease in assets and expenses. Cash decreases $1,700, and the
specific expense categories (Rent Expense, Salaries and Wages Expense, and Utilities
Expense) decrease owner’s equity by the same amount. The effect of these payments on the
equation is:

The two sides of the equation now balance at $19,600. Three lines in the analysis indicate the
different types of expenses that have been incurred.
Transaction (8). Payment of Accounts Payable. Softbyte pays its $250 Daily News bill in
cash. The company previously [in Transaction (5)] recorded the bill as an increase in Accounts
Payable and a decrease in owner’s equity.
Observe that the payment of a liability related to an expense that has previously been recorded
does not affect owner’s equity. The company recorded this expense in Transaction (5) and
should not record it again.
Transaction (9). Receipt of Cash on Account. Softbyte receives $600 in cash from customers
who had been billed for services [in Transaction (6)]. This does not change total assets, but it
changes the composition of those assets. Note that the collection of an account receivable for
services previously billed and recorded does not affect owner’s equity. Softbyte already
recorded this revenue in Transaction (6) and should not record it again.

Transaction (10). Withdrawal of Cash by Owner. Ray Neal withdraws $1,300 in cash from the
business for his personal use. This transaction results in an equal decrease in assets and
owner’s equity. Both Cash and Owner’s Drawings decrease $1,300, as shown on the next
page.
Observe that the effect of a cash withdrawal by the owner is the opposite of the effect of an
investment by the owner. Owner’s drawings are not expenses. Expenses are incurred for the
purpose of earning revenue. Drawings do not generate revenue. They are a disinvestment. Like
owner’s investment, the company excludes owner’s drawings in determining net income.
Transaction Analysis
Accounting Profession in the Philippines
The regulatory body in accounting is the Board of Accountancy (BOA) which is under the
Professional Regulation Commission (PRC). To practice public accounting in the Philippines,
one must take and pass a licensure examination, most commonly known as the Certified Public
Accountant Licensure Exams (CPALE), which is conducted twice a year (May and October).
This board exam contains six subjects:

1. Financial Accounting and Reporting
2. The Advanced Financial Accounting and Reporting
3. Auditing Practice
4. Taxation
5. Management Advisory Services
6. Regulatory Framework for Business Transactions (Law)
When you pass the board exam, you are eligible to join the Philippine Institute of Certified
Public Accountants. The practice of accountancy in the Philippines can be classified into three
main areas:
a. Government Accounting - these are accountants who work in the government and
are concerned with the accounting of government transactions, as well as the receipts
and disposition of government funds.
b. Private Accounting - these are accountants hired as employees or consultants in a

company.
c. Public Accounting - public accounting is the exercise of the following: auditing,

taxation, and management advisory services (MAS). It is considered as “public
accounting” because practitioners of these exercises require regulation by the
government.
Comparing Accounting
Accounting vs Auditing: Accounting is an information system that records, measures,
processes, and communicates financial information about an identifiable economic entity.
Auditing is the principal service that is rendered by a CPA who is engaged in public accounting
practice. If the accountant writes the financial statements, then the auditor checks the accuracy
of the financial statements.
● External Auditors are those who audit the records of a client. The aforementioned
example above about financial statements are examples of external auditors, only if the
auditor is not employed by the company and must exist outside of the company. This is
why we have auditing firms.
● Internal Auditors are those who perform routine tasks in detailed checking of the
company's accounting procedures. Mostly these auditors do not check the financial
statements, but rather the process of making them.
Accounting vs Bookkeeping: Accounting includes the analysis and interpretation of financial

statements, income tax work, design and installation of an accounting system’s audits,

budgets, and feasibility studies. Bookkeeping involves mechanical and repetitive recording
and classifying procedures related to the business activities, until the information is
summarized and reported in the form of financial statements. Essentially, bookkeeping is a
part/phase of the accounting process, as it only concerns the measuring/recording.
Accounting vs Accountancy: Accountancy is a profession, while Accounting is an activity.

Accountancy is where members are engaged in the collection of financial data, the summary,
and the presentation of information to intended users for making an effective decision.
Accounting includes the analysis and interpretation of financial statements.
Financial Accounting vs Managerial Accountancy: Financial Accounting is focused on the

recording of business transactions and the periodic preparation of reports on financial position
and results of operation. This is the stage of accounting that is concerned with creating the
financial statements, essentially this stage starts from recording to creating the financial
statement. Managerial Accounting incorporates cost accounting, or specific information
needed by the internal users. A useful tool in achieving the functions of management such as
short/long range plans, measure the success of these plans, identify areas that require special
attention, choose from among available alternative courses of action. Unlike financial
accounting, managerial accounting does not focus on financial statements alone, but they help
draft up budgets, plans, etc. that are used to solve managerial problems in a company.
The Principle of Debit and Credit

Accounts are specific units that indicate assets, liabilities and owner's equity. Think of these as
sub-units that will help the business to specifically track its operations.
1. Real accounts - or also called permanent accounts. These are accounts whose
balances transfer from one accounting period to another. These are assets, liabilities,
and equity accounts. These are transferable from one accounting period to another.
2. Nominal accounts - or also called temporary accounts. The balances of these

accounts are only applicable for one accounting period and cannot be transferred to
another. These are Revenue and Expense accounts. These are not transferable from
one accounting period to another.
Types of Specified Accounts

Assets
Conceptual framework is the overall standard framework for accounting. And according to the
conceptual framework, it defines assets as the present (the asset should be in the current

possession (physical or constructive) of the entity) economic resource (the asset should
provide the entity economic benefits in the future) controlled (the entity should have the liberty
(right) to use the asset on whatever they like to use it for) by the entity as a result of past events
(the asset was acquired due to an event that happened in the past.)
Name of Asset Account Description
Cash includes cash on hand consisting of coins,

currency, and undeposited checks, money
orders and drafts and cash in banks.
Accounts Receivable include trade accounts usually from normal

sale of goods and services.
Notes Receivable include accounts to be received from

customers usually evidenced by a
promissory note.
Inventory include goods (merchandise or finished

goods) held for sale in the normal course of
business plus, in the case of manufacturing
companies' raw materials and goods in
process.
Supplies include short-term consumables purchased

by the company.
Property, Plant, and Equipment tangible assets that are held by an enterprise
for use in the production or supply of goods
or services or for rental to others or for
administrative purposes and which are
expected to be used during more than one
period.
Example: land, buildings, machinery,

equipment, furniture and fixtures, vehicles.
Prepaid Assets assets created by prepayment of cash or

incurrence of a liability, also known as
collateral.
Liabilities
Liabilities are a present obligation (the liability should be outstanding, meaning the entity has a
responsibility (obligation) towards the liability) of the entity to transfer (the entity should have to

pay or give up something in the future to settle the liability) an economic resource (the liability
should obligate the entity to entail economic outflow of benefits in the future) as a result of past
events. (the asset was acquired due to an event that happened in the past)
Name of Liability Account Description
Accounts payable Obligations arising from the firm's ongoing

including the acquisition of merchandise,
Notes/Loans payable materials, Supplies and services used in the
production and sale of goods or services.
Accrued expense payable expenses incurred as of the financial reporting date

for which cash has not been paid.
Unearned revenues or advance collection from customers relating to

advances from customers future delivery of goods and services.
Long-term loan payable long-term debt which maturity extends beyond

one year and is evidenced by a formal
document called promissory note issued in
exchange for a loan from a bank.
Installment notes payable represent indebtedness that is repaid through

installment over a period exceeding one year.
Equity
The residual ownership of the business owner over the business assets, after all liabilities are
paid.
Name of Equity Account Description
Owner, capital represent the amount of investment the owner has

made in the business. The amount of net income
and net loss during the year also flows in here.
Owner, drawings represent the amount of withdrawals made by the

owner during the year.
Income is an increase in economic benefits that result in increases in equity (other than those
related to contributions from shareholders). Income includes both revenues (resulting from
ordinary activities) and gains. Expenses are a decrease in economic benefits that result in
decreases in equity (other than those related to distributions to shareholders). Expenses

include losses that are not the result of ordinary activities. The forms of business organizations
can be classified based on its ownership; typically, on how many owners it has.
1. Sole proprietorships - businesses owned by one person only.
2. Partnerships - businesses formed and owned by two or more persons.
3. Corporations - businesses formed by 5 or more people and owned by many people.
Businesses can also be classified based on the main activity it partakes in.
1. Service-oriented entities - are business entities that provide services to its clients.
2. Merchandising entities - are business entities that buy products from suppliers and
sell the very same to customers.
3. Manufacturing entities- are business entities that buy raw materials and transform
them into new products.
Movement of Accounts
An account is an individual accounting record of increases and
decreases in a specific asset, liability, or owner’s equity item. In
its simplest form, an account consists of three parts: (1) a title, (2)
a left or debit side, and (3) a right or credit side. Because the
format of an account resembles the letter T, we refer to it as a T
account.
The term debit indicates the left side of an account, and credit indicates the right side. They
do not mean increase or decrease, as is commonly thought. We use the terms debit and credit
repeatedly in the recording process to describe where entries are made in accounts. For
example, the act of entering an amount on the left side of an account is called debiting the
account. Making an entry on the right side is crediting the account.
When comparing the totals of the two sides, an account shows a debit balance if the total of
the debit amounts exceeds the credits. An account shows a credit balance if the credit
amounts exceed the debits. Note the position of the debit side and credit side.
After identifying which accounts are affected in each transaction, the accountant should know
if the account will be increased or decreased. The movement will be summarized through a
debit or credit in the applicable account depending on the normal balance of the account.

OWNER’S CAPITAL
ASSETS = LIABILITIES + + REVENUE - EXPENSES
OWNER’S DRAWINGS
Debit and Credit of Accounts

● This means, if you debit Cash you are actually increasing the Cash account. This is
because the normal balance of the Cash account is debit, because Cash is an asset.
● Consequently, if you credit Loans Payable, you are actually increasing the Loans
Payable account. This is because the normal balance of the Loans Payable account is
credit, because Loans Payable is a liability.
● Lastly, when an account moves through its opposite balance, it decreases. For
example, when you credit lnventory, it means you are decreasing the Inventory account,
because credit is the opposite of debit, which is the normal balance of the Inventory
account.
Each transaction must affect two or more accounts to keep the basic accounting equation in
balance. In other words, for each transaction, debits must equal credits. The equality of debits
and credits provides the basis for the double-entry system of recording transactions.
Under the double-entry system, the dual (two-sided) effect of each transaction is recorded in
appropriate accounts. This system provides a logical method for recording transactions.
Debit/Credit for Assets and Liabilities
Asset accounts normally show debit balances. That is, debits to a specific asset account
should exceed credits to that account. Likewise, liability accounts normally show credit
balances. That is, credits to a liability account should exceed debits to that account. The
normal balance of an account is on the side where an increase in the account is recorded.
● It is a rule that both sides of the basic accounting equation (assets = liability + equity)
must be equal.
● It therefore follows that increases and decreases in liabilities will have to be recorded
opposite from increases and decreases in assets.
● Thus, increases in liabilities must be entered on the right or credit side, and decreases
in liabilities must be entered on the left or debit side.
Asset accounts normally show debit

balances. That is, debits to a specific
asset account should exceed credits to

that account. Likewise, liability accounts normally show credit balances. That is, credits to a
liability account should exceed debits to that account. The normal balance of an account is on
the side where an increase in the account is recorded. Knowing the normal balance in an
account may help you trace errors. For example, a credit balance in an asset account such as
Land or a debit balance in a liability account such as Salaries and Wages Payable usually
indicates an error. Occasionally,
though, an abnormal balance
may be correct. The Cash
account, for example, will have a
credit balance when a company
has overdrawn its bank balance
(i.e., written a check that
“bounced”).
Debit/Credit for Owner’s Equity
Investments by owners are credited to the Owner’s

Capital account. Credits increase this account, and
debits decrease it. When an owner invests cash in the
business, the company debits (increases) Cash and
credits (increases) Owner’s Capital. When the owner’s
investment in the business is reduced, Owner’s
Capital is debited (decreased).
An owner may withdraw cash or

other assets for personal use.
Withdrawals could be debited
directly to Owner’s Capital to
indicate a decrease in owner’s
equity. However, it is preferable
to use a separate account,
called Owner’s Drawings. This separate account makes it easier to determine total
withdrawals for each accounting period. Owner’s Drawings is increased by debits and
decreased by credits. Normally, the drawings account will have a debit balance.
Debit/Credit for Revenues and Expenses
Revenues and Expenses. The purpose

of earning revenues is to benefit the
owner(s) of the business. When a

company earns revenues, Owner’s equity increases. Therefore, the effect of debits and credits
on revenue accounts is the same as their effect on Owner’s Capital. That is, revenue accounts
are increased by credits and decreased by debits.
Expenses have the opposite effect: Expenses decrease owner’s equity. Since expenses
decrease net income, and revenues increase it, it is logical that the increase and decrease
sides of expense accounts should be the opposite of revenue accounts. Thus, expense
accounts are increased by debits and decreased by credits.

Journalizing Service Business Transactions
Recording of Transactions
The formal term to refer to this stage of the accounting cycle is journalization. An accountant
journalizes accountable business transactions in an accounting record called the journal. The
journal is called the book of original entry. This is where accountable business transactions are
initially recorded. The principles of debits and credits are heavily used in this accounting
record.
1. Date
2. Particulars
3. Ledger Reference (LN)
4. Debit Column (Dr)
5. Credit Column (Cr)
6. Month and day
7. Account names
8. Money Columns
For each transaction the journal shows the debit and credit effects on specific accounts.
Companies may use various kinds of journals, but every company has the most basic form of
journal, a general journal. Typically, a general journal has spaces for dates, account titles and
explanations, references, and two amount columns. The process of recording an accountable
business transaction is called journalizing and each record is called a journal entry.

Types of Journal Entries
A journal entry that includes only one debit and credit is called a simple journal entry.
Example: On March 1, Robert invested P500,000 in his new business, Kitchen Cai.
A journal entry that includes only more than one debit and/or credit is called a compound
journal entry. This is allowed, as long as the total debits are equal to the total credits.
Example: On March 2, the business purchased supplies worth P5,000, half paid in cash, while
the other is in credit.
The entire group of accounts maintained by a company is the ledger. The ledger keeps in one
place all the information about changes in specific account balances. Companies may use
various kinds of ledgers, but every company has a general ledger. A general ledger contains all
the asset, liability, and owner’s equity accounts.
A chart of accounts (COA) is an index of all the financial accounts in the general ledger of a
company. In short, it is an organizational tool that provides a breakdown of all the financial
transactions that a company conducted during a specific accounting period.

Introduction to Merchandising Businesses
The Accounting Cycle
The accounting cycle is a holistic process that records a business's transactions from start to
finish, helping businesses stay organized and efficient. The cycle incorporates all the
company's accounts, including T-accounts, credits, debits, journal entries, financial statements
and book closing. It consists of the following:
Merchandising
In ascertaining profit for a service business, a basic income statement is needed; that is net
income equates to revenues subtracted by expenses, which can be expressed as:
NET INCOME = REVENUES - EXPENSES
On the other hand, a merchandising business is a business form where a business sells a
particular or a group of products. More commonly known as buy-and-sell business. For
merchandising, the net income equates to net sales deducted by cost of goods sold.

In merchandising, it is important to take into account the asset called the merchandise
inventory account, which is exclusive only to merchandise entities. This account contains all
the products being sold. Similarly, in service-providing business, the equivalent would be the
supplies account or equipment account, but these are not being sold. For manufacturing
businesses, the equivalent will simply be an inventory account.
Sales
Revenues (in merchandising) are called sales, which represents the revenues collected/earned
by the merchandising business. It follows the same rule as revenue accounts when it comes to
the accounting equation and types of specified accounts, just under a different name. The
following are contra-sales, which are the subtractive elements that can decrease the value of
sales.
● Sales accounts refer to membership programs or events wherein the merchandise is

sold at a discounted price.
● Sales returns are when a merchandise is returned if it is damaged or in poor

quality/condition.
● Sales allowances act as a refunding account for damaged merchandise, similar to

sales returns but instead of being returned, it is paid for.
Net sales arise from the sale of goods, and it can be defined as the overall final value after
deducting the sales accounts, returns, and allowances from the gross sales (which are sales
that have not yet been deducted). The equation can then be defined as:
GROSS SALES
- SALES ACCOUNTS
- SALES RETURNS
- SALES ALLOWANCES
= NET SALES
In contrast, merchandising businesses earn profit by buying and selling goods. Merchandising
entities use the same basic accounting methods as service companies. But the process of
buying and selling merchandise requires some additional concepts. The other operating
income and other operating expenses are affected to get the operating profit.

Expenses
There are many different types of expenses, one of the most common ones being the cost of
goods sold:
Cost of Goods Sold (COGS) (also known as the cost of sales) represents the cost of inventory
the entity has sold, it refers to what was spent in order to buy the product or merchandise that
has been sold. Essentially, it is the inventory, similar to supplies. When it hasn’t been used, it’s
considered an asset, when it has been sold/used, it is considered as an expense or COGS. It is
used to determine how much it costs when buying from the supplier, or the amount
needed/used in order to run a business.
In a merchandising business, net sales arise from the sale of goods while cost of sales or
cost of goods sold represents the cost of inventory the entity has sold.
In order to determine the COGS, it must be summed of all the individual product’s cost price
when it has been multiplied by the amount of times it has been sold. The cost price, not the
selling price. If it is multiplied by the selling price, it would be considered as the gross profit.
Gross profit is the difference between net sales and cost of goods sold. Which can be
expressed as:
GROSS PROFIT = NET SALES - COST OF GOODS SOLD
All other different types of expenses are simply deducted from the gross profit, which is used to
determine net income. Other examples of expenses include:
1. Selling expenses - expenses related in order to sell the product or merchandise.

Examples are delivery expenses, marketing expenses, etc.
2. Administrative expenses - expenses related to the administrators of the business. The

difference between sellers and the admins, is that the sellers are the ones running the
store, while the admins are the ones running the business.

Net Income
Net income is the amount of accounting profit a company has left over after paying off all its
expenses. Net income is found by taking sales revenue and subtracting COGS, SG&A,
depreciation, and amortization, interest expense, taxes and any other expenses.
Net income is the last line item on the income statement proper. Some income statements,
however, will have a separate section at the bottom reconciling beginning retained earnings
with ending retained earnings, through net income and dividends. It can be expressed as:
NET INCOME = GROSS PROFIT - OTHER EXPENSES
Source Documents
Merchandising businesses use various business forms and documents to help identify
transactions to be recorded in the books. These source documents contain vital information
about the nature and amount of transactions.
● A sales invoice is prepared by the seller and sent to the buyer. It specifies the amount
of sales, payment terms. Most commonly known as a receipt.
● A bill of lading is a document issued by the carrier that specifies contractual conditions
and terms of delivery, such as insurance, ownership, and other gray legalities that are
solidified.
● A statement of account is a formal notice to the debtor that details the accounts
already due.
● A purchase requisition is a written request to the purchaser of an entity from an

employee or user department of the same entity that goods be purchased.
● A purchase order is an authorization made by the buyer to the seller to deliver the
merchandise.
● The receiving report is a document containing information about goods received from
a vendor.
● A credit memorandum is a form used by the seller to notify the buyer that his account
is being decreased due to errors or other factors.

Freight
The sales agreement should indicate who—the seller or the buyer—is to pay for transporting
the goods to the buyer’s place of business. When a common carrier such as a railroad,
trucking company, or airline transports the goods, the carrier prepares a freight bill in accord
with the sales agreement.
Freight ownership terms are expressed as either FOB shipping point or FOB destination. The
letters FOB mean free on board.
● Thus, FOB shipping point means that the seller places the goods free on board the
carrier, and the buyer pays the freight costs (freight-in, which means it is added to the
merchandise inventory). Ownership is transferred the moment the goods are picked
up.
● Conversely, FOB destination means that the seller places the goods free on board to
the buyer’s place of business, and the seller pays the freight (freight-out, which means it
is considered as an expense, specifically a delivery expense). Ownership is transferred
when the goods reach the destination.

Recording for Merchandising Entities and Systems
The following is a graph of a common
operating cycle of a service business.
The graph starts with cash from the
customer, given to the service provider
who uses the cash for various expenses
related to the business, then the
business bills the client for the amount.
For merchandising entities, the process is

similar. The following is a common
operating cycle of a merchandising
business, cash is used to purchase
goods for sale, the business sells and
delivers these goods. Billing the client is
only optional for large companies who
have a credit system or programs for
loyal customers.
Unlike service entities who use “revenue” accounts for their main source of income,
merchandising entities utilize the Sales account for the sale of their goods. Like any other
revenue accounts, Sales have a normal credit balance.
Purchases are goods that the merchandising business bought from their suppliers to be sold.
Accounting for Merchandising Entities is the accounting for the goods purchased by the
merchandiser from their suppliers.
Every time a good is sold by the merchandiser, the cost of that good is also recognized as an
expense by the merchandiser. The timing of recognition of the Cost Of the Goods Sold
depends on which inventory system the merchandiser maintains.

Inventory Accounting Systems
In accounting for merchandising entities, the system for Accounting for Purchases and Cost Of
the Goods Sold will depend on what kind of items does the merchandiser have:
● If the merchandiser sells items that are low in quantity, but high in price (such as
jewelry, cars, furniture etc.), the perpetual inventory system is the appropriate
accounting system for him;
● If the merchandiser sells items that are high in quantity, but low in price (such as school
supplies, grocery items, etc.), the periodic inventory system is the appropriate
accounting system for him.
In the periodic inventory system, the inventory account is not moved for every purchase and
sale transaction. There is also no COGS or expense account in the periodic inventory system. It
uses a different set of formulas which will be discussed later.
Perpetual Inventory System

The perpetual inventory system is the highly recommended type of system for most
merchandising businesses. In this system, for every purchase and sale of goods (COGS), there
is an appropriate movement in the merchandise inventory account. COGS are computed
immediately, debiting COGS and crediting sales. The main features of the perpetual inventory
system are as follows:
● Maintenance of the Merchandise Inventory account, which means that every purchase,
every sale, the account is affected.
● Maintenance of the Cost of Goods Sold account (an expense account), which means
that every sale, it is updated regularly.
● Inventory counts confirm the amount of the Merchandise Inventory account.
In order to compute the Merchandise Inventory (asset) account, the product quantity/amount is
multiplied by its original cost price. If there are multiple products, it must be multiplied first
before being added together, then debited. For every sales transaction, there are two entries:
the sale, and the Cost of Goods Sold.
In order to calculate the sales: the selling price is multiplied by the amount of times it
has been sold. This will fall under the appropriate asset account.

The Merchandise Inventory account is then deducted under the Cost of Goods Sold
(expense account). In order to calculate this COGS, the cost price is multiplied by the
amount of times it has been sold.
Discounts
One of the few prominent features of a merchandising business is its ability to sell in bulk, or
what we call wholesale. Discounts are important in the business of wholesaling because the
imposition of discounts is used in order to encourage buyers to purchase goods. Discounts are
debited.
Discounts can be applied for both purchases and sales, and the owner may give or receive
them. Generally, there are two kinds of discounts in a manufacturing business:
● Cash discounts are used to encourage customers to pay early. Between these two
discounts, cash discounts are the only one journalized.
● Trade discounts are given to encourage wholesale purchases (examples are buy one
get one).
Trade Discounts Cash Discounts
Trade discounts are usually large in Cash discounts are small in percentage and
percentage, and two-digits (e.g. 10%, 30%, usually one-digit only (e.g. 2%, 3%, 5%) and
50%) given to customers who purchased on credit.
The objective of a trade discount is to In a cash discount, the customer is

encourage the customer to buy in encouraged to pay his billed amount on an
bulk/wholesale. earlier date.
Usually written as: “Sold P500,000 goods, Usually written as: “Sold P500,000 goods,
20%, 30%, 10%” This can be interpreted as 3/10, 2/15, n/30” This can be interpreted as
500,000 x 80% x 70% x 90% 500,000 can be reduced by 2% if collected
in 10 days, 3% if collected in 15 days and
no discount if within 30 days
Trade discounts are NOT journalized. Cash discounts are journalized (assume 3%):
Cash 252,000 Cash 485,000
Sales 252,000 Sales Discount 15,000
Accounts Receivable 500,000
All contra-sales (discounts, returns, allowances) are debited. Discounts are only journalized
once there has been a payment transaction, accounts/notes payable do not apply. In order to
calculate a trade discount, find the difference of the percentage discount given, (i.e. 10% =

90%) then multiply the difference after calculating the sales or COGS. If there are multiple
discounts, simply use both (x*90%*80%).
When on the receiving end of a discount, the same principle applies: discounts are only
journalized once there has been a payment transaction, and are only journalized once the
accounts/notes payable have been paid.
Periodic Inventory System

Technically and ideally, the perpetual inventory system is the most appropriate and most
efficient inventory system in comparison to both systems. Under the periodic inventory
system, all purchases made between physical inventory counts are recorded in a purchases
account. When a physical inventory count is done, the balance in the purchases account is
then shifted into the inventory account, which in turn is adjusted to match the cost of the
ending inventory.
Its main features include:
● There is no maintenance of the Cost of Goods Sold account, it is calculated separately

with a formula.
● There is a Merchandise Inventory, but it is not updated. There will only be two accounts
that appear in the merchandise inventory: its ending balance or its beginning balance.
● Inventory counts are extremely important and needed, otherwise there will be no other
way to track inventory. COGS and Merchandise Inventory will only be known until after
the period.
To amend for the lack of COGS and Inventory accounts, there are other accounts specifically
for the periodic inventory system, which are in the aforementioned COGS formula stated as
followed:
COGS = BEGINNING INVENTORY + PURCHASES - PURCHASE

DISCOUNTS & ALLOWANCES + FREIGHT IN - ENDING INVENTORY
NET SALES - COGS = GROSS PROFIT

Similar to net sales, the underlined accounts above indicate what is called as ‘net purchases.’
The beginning inventory is the remaining inventory from the last period, if the net purchases are
then added, it is called the cost of goods available for sale. If it is sold, it will be known as the

cost of goods sold, if it is unsold, it will be the remaining inventory (beginning inventory once
the next period comes.)
General Ledger and Posting Process

The journal and the ledger have two similar formats, but the noticeable difference is that the
journal is the book of original entry, and the ledger is the book of the final entry. Adding
information and entries in journals is called journalizing, in ledgers, it is called posting.
Everything that has been discussed up until this point, are journal entries.
In ledgers, there are many different types of specific ledgers for specific accounts (i.e. accounts
receivable, sales, cash, etc.) the one to be discussed today is the general ledger, which
function similarly but differently from journals.
● Firstly, the ledger must have the chart of accounts and their respective classifications
on the accounting equation (assets, liabilities, owner’s equity, revenue, & expenses) in
that specific and chronological order.
● Similar to the t-account and journal, for every entry there is another entry, but in the
ledger, the debit and credit entries are not always equal because of the nature of the
account itself. Otherwise, the date, debit, and credit are the same in terms of movement
of the account.
● The ledger heavily depends on the journal, hence the ‘JN’ column (Journal Reference)
in between the particulars and the debit/credit. The particulars describe the transaction
made instead of the accounts affected.
● When the accounting period is over, a bar at the bottom is added after posting is
finished, where the total sum of the debit/credit is calculated. After the input of values,
the normal balance of the account must always have a bigger value than the opposite
balance. While it is mathematically possible for the opposite balance to have the bigger
value, it only shows miscalculations and the incompetence of the accountant posting
and mistakes in the journalizing process.
● The ending balance is calculated by subtracting the normal balance from its opposite
balance (i.e. debit-credit if asset). The ending balance of the account will be presented
in the financial statement.
● The same principle applies for periodic and perpetual inventory systems, wherein the
cost of goods sold and merchandise inventory as well as purchase accounts are

present. Except the merchandise inventory account is present in both periodic and
perpetual inventory systems.
Guide
However, in the periodic inventory system, you only show the beginning and ending balances.
Refer to the tables below for the chart of most commonly used accounts and the debit and
credit balances.
Assets Liabilities Owner’s Equity Revenue Expenses
- Cash - Accounts - Owner’s - Sales Revenue - Purchases

- Equipment Payable Capital - Sales - Purchase
- Supplies - Loans payable - Owner’s Discounts discounts
- Accounts - Notes payable drawings - Sales Returns - Purchase
Receivable - Unearned & Allowances Returns &
- Prepaid revenue Allowances
expenses - Freight-out
- Merchandise
inventory
OWNER’S CAPITAL
ASSETS = LIABILITIES + + REVENUE - EXPENSES
OWNER’S DRAWINGS
Debit Credit
- Assets - Liabilities
- Owner’s Drawings - Owner’s Capital
- Expenses - Revenue
- Merchandise Inventory - Sales
- Cost of Goods Sold - Contra-Purchases (Purchase Discounts,
- Freight-in Purchase Returns & Allowances)
- Contra-Sales (Sales Discounts, Sales - Contra-Assets
Returns & Allowances) - Accumulated Depreciation
- Purchases

Worksheet and Trial Balances
A worksheet is a document used within the accounting department to analyze and model
account balances. A worksheet is useful for ensuring that accounting entries are derived
correctly. It can also be helpful for tracking the changes to an account from one period to the
next.
● It starts with three headings: the company name, the document name, and the date
formatted as ‘For the Month Ending DD YYYY.’
● The account title/particulars column on the left side (in the same order as ledgers:
assets, liabilities, owner’s equity, revenue, & expenses), and the five parts/components
as columns on the right: (unadjusted) trial balance, adjustments, adjusted trial balance,
income statement, and the balance sheet. Each part has a debit and credit column,
which always must be equal.
● The trial balance contains the ending balance from the ledgers, and whether or not it
is in debit/credit is dependent on where the ending balance is on the ledger.
Accounting information is valued when it is communicated early enough to be used for

economic decision-making.
Adjusting Entries
In order for revenues to be recorded in the period in which they are earned, and for expenses to
be recognized in the period in which they are incurred, companies make adjusting entries.
Adjusting entries ensure that the revenue recognition and expense recognition principles are
followed. Adjusting entries are necessary because the trial balance—the first pulling together of
the transaction data—may not contain up-to-date and complete data. This is true for several
reasons:
1. Some events are not recorded daily because it is not efficient to do so. Examples are
the use of supplies and the earning of wages by employees.
2. Some costs are not recorded during the accounting period because these costs expire
with the passage of time rather than as a result of recurring daily transactions.
Examples are charges related to the use of buildings and equipment, rent, and
insurance.
3. Some items may be unrecorded. An example is a utility service bill that will not be
received until the next accounting period.

Periodicity Concept
After establishing the accounting process steps so far (analyzing, journal, ledger, and trial
balance) the next step is the adjusting process, similar terms include fixing or updating the
amounts displayed in the trial balances.
From the previously discussed worksheet, there is a period of time provided in the third
heading. To provide timely information, dividing the economic life of business into artificial time
periods is essential. This assumption is referred to as the periodicity concept.
When we present accounting information to users in the form of financial reports, such as the
financial statements, they must be presented in time periods. Divisions of these time periods
can be weekly, monthly, bi-monthly, quarterly, but the most common form is annually.
Entities differ in their choice of the accounting year: fiscal, calendar or natural.
● A fiscal period is a period of any twelve consecutive months.
● Calendar periods are annual periods ending December 31.
● Natural periods end when business activities are at their lowest level of the annual
cycle. This is the least commonly used in accounting.
● A period of less than twelve months is an interim period.
Importance of Adjustments
● Adjusting entries are made to reflect in the accounts information on economic activities
that have occurred but have not yet been recorded.
● Adjusting entries assign revenues to the period in which they are earned, and expenses
to the period in which they are incurred.
● Entries are only adjusted every end of the month/year after the trial balances.
● Adjusting entries involve changing account balances at the end of the period from what
is the current balance to what is the correct balance for proper financial reporting.
● In short, adjustments are needed to ensure that the revenue recognition and expense
recognition principles are followed.

Revenue and Expense Recognition Principles
The adjustment process relies on the revenue and expense recognition principles, which are
stated below:
● Revenue is recognized when it is probable that economic benefits will flow to the
enterprise and these benefits can be measured reliably.
● Revenue should be recognized when it is earned.
● In most cases, revenue is earned in the accounting period when the services are
rendered or the goods sold are delivered.
On the other hand, the expense recognition principle is the basis for recording expenses.
● Expenses are recognized when it is probable that a decrease in future economic

benefits has arisen, and that the decrease can be measured reliably.
● The expense recognition principle directs accountants to identify all expenses incurred
during the accounting period, to measure the expenses against revenues.
● To match expenses against revenues means to subtract the expenses from the
revenues to compute profit or loss.
There are three broad applications of the expense recognition principle.
1. Expenses are recognized in the income statement on the basis of a DIRECT

ASSOCIATION between the costs incurred and the earning of specific items of income.
Example: JJ Realty pays commission to their sales agents every time a sale
arises. This can be explained by the previous statements above.
2. When economic benefits are expected to arise over several accounting periods and the
association with income can only be broadly determined, expenses are recognized on
the basis of SYSTEMATIC AND RATIONAL ALLOCATION.
Example: JJ Realty recognizes depreciation (wear and tear of an asset) of its

property, plant and equipment every month. The drop in value of an asset can
be defined as a depreciation expense. This can be explained by a formula and
the systematic and rational allocation principle, there are expenses that
cannot be partnered like salaries and rent.

There are expenses that can only be partnered because the expenses must be
allocated to the life of an asset (i.e. property, plant, and equipment) just like the
depreciation expense.
3. Lastly, some expenses are recognized IMMEDIATELY when an expenditure produces

no future benefits. Example: 33 Realty pays officers' salaries, distribution costs, selling
expenses and amounts paid to settle lawsuits.
Types of Adjusting Entries

There are two types of adjusting entries, deferrals and accruals. In general, when adjusting
entries, it will always affect the debit and credit accounts of at least one of the A/L/E
(Assets/Liabilities/Equities) and the R/E (Revenues/Expenses), as a result affecting the balance
sheet and income statement respectively.
Deferrals
For deferrals, adjusting entries are necessary, especially for assets and liabilities. From the
word ‘defer,’ the use of deferral is to delay. There are time-based deferrals and
performance-based deferrals.
There is a REVENUE that was first a LIABILITY. This is the clearest type of adjusting entry. (i.e.
Unearned Revenue)
Similarly, There is an EXPENSE account, instead of initially recognizing it as an expense, it is

written as an ASSET. Usual accounts affected are:
● Prepaid Expenses/Assets (Insurance, Prepaid Rent, Subscriptions)
● Bad debts, which are receivable accounts that cannot be collected.
● Contra-Assets
● Depreciation expense
Adjusting entry is necessary wherein the account will ‘expire’ (i.e. asset is incurred as expense,
liability is earned as revenue). When deferrals occur, the expense (+) is debited and the asset
(-) is credited, and the liability is debited (+) while the revenue is credited (-).
No matter how small the amount, accounts must be adjusted based on its given
periodical expiration (i.e. every month).

Pro rata is a Latin term used to describe a proportionate allocation. It essentially translates to
"in proportion," which means a process where whatever is being allocated will be distributed in
equal portions.
When calculating for the prepaid rent and rent expense in the adjustment entries, the amount
paid is divided by its determined period of expiration (6 months, 3 months, etc.) then multiplied
by the period of expiration.
Example: Jake paid a total of P60,000 when the month began, which represents
advanced payment of rent worth 6 months. The 60k is divided by six months, then
multiplied by one as a representation of the one month paid.
Depreciation
Depreciation is a reduction in the value of an asset with the passage of time, due in particular
to wear and tear. However there is only a portion of the asset that is turned over to expense.
Depreciation is an allocation concept, not a valuation concept. That is, depreciation

allocates an asset’s cost to the periods in which it is used. Depreciation does not
attempt to report the actual change in the value of the asset.
Unlike Prepaid Rent, Unearned Revenue, and Fixed Assets, Depreciation is difficult to measure.
However, it can be defined as the difference between the book value and the salvage/residual
value divided over its useful life, which can be expressed as:
𝑏𝑜𝑜𝑘 𝑣𝑎𝑙𝑢𝑒 − 𝑠𝑎𝑙𝑣𝑎𝑔𝑒 𝑣𝑎𝑙𝑢𝑒

𝐷𝑒𝑝𝑟𝑒𝑐𝑖𝑎𝑡𝑖𝑜𝑛 = 𝑢𝑠𝑒𝑓𝑢𝑙 𝑙𝑖𝑓𝑒
Book values are the given value of the Fixed Asset, but not all Fixed Assets have salvage
values (%). Useful life is more often than not estimated.
In adjustments, fixed asset accounts are not directly credited when the Depreciation expense
account is debited, because it violates the historical cost principle. Instead, what is credited is
the Accumulated Depreciation - [account], which is a contra asset account.
The Depreciation expense account can be debited for all depreciation accounts, and the
Accumulated Depreciation accounts must be separate for each asset, but it can be journalized
under one entry so long as it was calculated under the same useful life unit.

Bad Debts
Bad debt is the term used for any loans or outstanding balances that a business deems
uncollectible. This is where the asset (Accounts Receivable) turns into an expense
(Bad/Doubtful debts) There are two stages of bad debts:
1. The first stage is the estimate, wherein the business attempts to foresee potential
customers that do not pay. This can be achieved through analysis of customer data.
2. The second stage is confirmation, or writing-off. After multiple attempts of contact or

asking for payment, it will be written-off. The entry to write off the bad account under
the direct write-off method is: Debit Bad Debts Expense (to report the amount of the
loss on the company's income statement) and Credit Accounts Receivable (to remove
the amount that will not be collected).
Estimation is journalized in the adjusting entry, wherein you take the accounts receivable and
multiply it by the percentage estimation and journalize that value. Like depreciation, when the
Bad Debts account is debited, the Accounts Receivable account is not directly credited, it has
its own contra account called Allowance for Bad Debts.
Accruals
Previously, deferrals incur/earn previously recognized accounts in the form of assets or

liabilities into expenses or revenue respectively. Accruals have no initial amount or account,
and must be recognized immediately. Often found in salaries, utilities, and rent. These are the
most simple types of accruals.
Example: A company has to pay a worker’s salary on June 30, but can pay on July 5.
According to the expense/revenue recognition principle, the expense must be
recognized immediately.
Solution: So for July 30, salaries expense is debited and salaries payable (also known
as accrued salaries payable) is credited. For July 5, salaries payable is debited and
cash is credited.
Adjusting entries only happens at the end of the month, and they are only made if the owner
has no intention of paying in that month. Though there are some cases wherein the expense
period is split between the months.
Example: Employees are paid 2,500 every week (5 day workweek). There are three
employees. The first three days of the last week of the month fell on the 29th, 30th, and
31st. While the last two days fell on the 1st and 2nd day of the next month.

Solution: Expense will only be recognized up until the last month only (29th, 30th, and
31st.) For the adjusting entry, the salary expense is debited and the salaries payable is
credited, and the amount debited/credited will only be for those three days. For the
next month’s entry, salaries payable and salaries expense are both debited and cash is
credited.
Interest only applies in this accrual context when we (the owner) are the one borrowing money.
Every month, interest expense must be recognized in order to calculate the cost of our debt. All
interest rates are good for one year. To calculate interest for the month, use the following
formula:
= borrowed amount x interest rate % x no. of months used / 12
Accrued revenue works similarly to accrued expense, the only difference is its normal balance.
Any type of expense can be accrued, as long as you plan to pay them in a future period.
Balance Sheet and Income Statement

There are two types of accounts to consider when making the balance sheet and income
statement:
● Real accounts include asset, liability, and equity accounts. These accounts are
permanent and cumulative, often using the phrase “as of.”
● Nominal accounts include revenue and expense accounts. These accounts are
temporary and limited, often using the phrase “for the period of.”
A balance sheet refers to a financial statement that reports a company's real accounts (assets,
liabilities, and equities) at a specific point in time, taken from the adjusted trial balance column.
This is also known as ‘Statements of Financial Position’.
There are categories within each real account of the balance sheet. Assets have current assets
and noncurrent assets.
● Examples of current assets are: cash or cash equivalent, assets sold or consumed in
the main operations of the business (merchandise), or any asset that can be
sold/mature within one year. Assume accounts receivable, prepaid assets are also
current assets unless stated otherwise.
● Noncurrent assets are any other assets that are non current (equipment, vehicles.) This
can also include contra-asset accounts such as accumulated depreciation of
equipment and vehicles.

Liabilities have similar classifications. There are current liabilities and noncurrent liabilities.
● Current liabilities are liabilities that are: related to the operating cycle (e.g. wages), to
be paid within one year after the accounting period. Examples of current liabilities
include accounts payable, salaries and utilities payable, and unearned revenue. Notes
payable are current liabilities only if the asset loaned for supplies or any asset used in
the operating cycle. Interest payable is only included if it is paid yearly.
● Noncurrent liabilities are simply liabilities that are not current. Examples include loans
payable and notes payable if they are to be paid in more than one year after the
accounting period.
An income statement refers to a financial statement that reports a company’s nominal

accounts (revenues and expenses) taken from the adjusted trial balance column. This is also
known as the ‘Profit and Loss (P&L) statement’, which summarizes the financial performance of
a business during a specific period, reporting revenues, cost of goods sold, overheads, and the
net profit attributable to shareholders.
The income statement reports the revenues and expenses for a specific period of time. The
income statement lists revenues first, followed by expenses. Finally, the statement shows net
income (or net loss). Note that the income statement does not include investment and
withdrawal transactions between the owner and the business in measuring net income.
In making the income statement, expenses are sorted into two groups (function of expense):
● Operating Expenses are expenses necessary for the business to function, which is the
majority of the expense accounts.
○ Selling expenses are expenses for merchandising entities (i.e. marketing,

advertising, delivery)
○ Administrative expenses are expenses such as rent expense, utilities expense,

etc. This is the most common type of expense.
● Non operating expenses are expenses that are not necessary for the business to
function (i.e. interest expense).
Revenue is as is, but is different from merchandising entities.
Balance sheet and income statement are the only columns in the worksheet wherein the debit
and credit values are not balanced, which is natural because of net income and net loss. What
should be balanced is their difference.

Financial Statements
The objective of accounting is to provide information about the financial position, performance,
and cash flows of an enterprise, which can be done through financial statements. Financial
statements (FS) are the by-product of the accounting cycle. Companies prepare five financial
statements from the summarized accounting data, and to be considered as complete financial
statements, they should include:
1. Statement of financial position, also known as the balance sheet. It shows the
assets, liabilities, and equities of the enterprise as of a given point in time. The purpose
of the balance sheet is to affirm the balance and equation known as the accounting
equation.
2. Statement of comprehensive income, also known as an income statement presents

the revenues and expenses and resulting net income or net loss for a specific period of
time. Here, we see all the revenue and expenses of the company, which shows the
performance over a given range of time.
3. Statement of changes in equity, also known as an owner’s equity statement, which

shows the movement or changes of the equity value in the balance sheet (statement of
financial position) as well as summarizing said changes only for a specific period of
time.
The owner’s equity statement reports the changes in owner’s equity for a specific
period of time. The time period is the same as that covered by the income statement. If
the owner makes any additional investments, the company reports them in the owner’s
equity statement as investments.

4. Statement of cash flows focuses on the cash amount in the balance sheet, as well as
summarizing information about the cash inflows (receipts) and outflows (payments) for a
specific period of time. It records movement starting from its beginning balance at the
start of the accounting period up until the end of the accounting period.
5. Notes to the financial statements contain the other remaining data, details, and
information about the previous four financial statements that cannot be included. These
notes are more qualitative rather than quantitative, unlike the previous four statements.
Closing Accounts
Closing, or clearing the accounts, means returning the account to a zero balance. Having a
zero balance in these accounts is important so a company can compare performance across
periods, particularly with income. It also helps the company keep thorough records of account
balances affecting retained earnings.
This is the optional part in the accounting process, but is often done at the end of the year (not
monthly). The accounts affected are only the nominal accounts (revenue and expenses)
In order to close the nominal accounts, there is a temporary account called the income
summary, which has the normal balance of debit.

Basic Accounting 1

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Basic Accounting 1

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Introduction to Accounting

● The American Institute of Certified Public Accountants (AICPA) defines accounting

● The American Accounting Association defines accounting as the process of

ACG001 Lecture & Textbook Notes

1. IDENTIFYING: As a starting point to the accounting process, an economic entity

An event can be recognized as an accountable event if: (1) it can be assigned an

a. External/Exchange Transaction - involves economic events between the

2. MEASURING/RECORDING: Once those events have been identified, it would record

Recording is the technical component of accounting, it is the bookkeeping, and

To make the reported financial information meaningful, the data is recorded in a

ACG001 Lecture & Textbook Notes

a. Recording/Journalizing - systematically maintaining a record of all economic

b. Classifying - sorting/grouping of similar and interrelated economic transactions

c. Summarizing - preparing of FS (financial statements.)

Users of Accounting Data

a. Investors (owners) use accounting information to make decisions to buy, hold,

b. Creditors (e.g. suppliers and bankers) use accounting information to evaluate

● Financial accounting provides economic and financial information for investors,

ACG001 Lecture & Textbook Notes

1. The International Accounting Standards (IAS) - the first batch of accounting

2. The International Financial Reporting Standards (IFRS) - a new set of standards

Underlying Assumptions in Accounting

ACG001 Lecture & Textbook Notes

I. Entity (Business Entity Principle)

2. Partnership - A business owned by two or more persons associated as partners. In

3. Corporation - A business organized as a separate legal entity under state corporation

II. Periodicity Concept

III. Monetary Unit

ACG001 Lecture & Textbook Notes

Quantifiability - transactions and events that can be objectively measured or quantified in

The Accounting Equation

ASSETS = LIABILITIES + OWNER’S EQUITY

● Resources a ● Claims against total ● Ownership claim on

ACG001 Lecture & Textbook Notes

● INCREASES IN OWNER’S EQUITY: In a proprietorship, owner’s investments and

● DECREASES IN OWNER’S EQUITY: In a proprietorship, owner’s drawings and

ACG001 Lecture & Textbook Notes

In summary, owner’s equity is increased by an owner’s investments and revenues from

The Expanded Accounting Equation

Observe that the equality

ACG001 Lecture & Textbook Notes

Observe that total

ACG001 Lecture & Textbook Notes

ACG001 Lecture & Textbook Notes

ACG001 Lecture & Textbook Notes

ACG001 Lecture & Textbook Notes

ACG001 Lecture & Textbook Notes

b. Private Accounting - these are accountants hired as employees or consultants in a

c. Public Accounting - public accounting is the exercise of the following: auditing,

Accounting vs Bookkeeping: Accounting includes the analysis and interpretation of financial

ACG001 Lecture & Textbook Notes

Accounting vs Accountancy: Accountancy is a profession, while Accounting is an activity.

Financial Accounting vs Managerial Accountancy: Financial Accounting is focused on the

The Principle of Debit and Credit

2. Nominal accounts - or also called temporary accounts. The balances of these

Types of Specified Accounts

ACG001 Lecture & Textbook Notes

Name of Asset Account Description

Cash includes cash on hand consisting of coins,

Accounts Receivable include trade accounts usually from normal

Notes Receivable include accounts to be received from

Inventory include goods (merchandise or finished

Supplies include short-term consumables purchased

Example: land, buildings, machinery,