The Accounting Equation and the Double Entry System | 3-7 The system recognizes business rather than just accounting events. «The system supports reduction in operating inefficiencies, * The system eliminates redundant data. STAGES OF DATA PROCESSING Processing of raw data into useful accounting information then finally into summarized reports follows the usual .input-processing-output progression, Each transaction entered into the accounting system should be supported by source documents like customer invoices, vendor invoices, deposit slips, checks, time cards and memos. These documents serve as evidence that a particular transaction occurred. They also provide the necessary details and supports. The computer, with the use of the accounting software, then processes the inputs. As will be discussed later, the manual system of journalizing, posting, preparing the trial balance and updating the accounts are done almost instantaneously. When required, the financial statements and other accounting reports can be viewed on the screen or printed as output documents. In many situations, manual systems are inferior to computerized systems in terms of productivity, speed, accessibility, quality of output, incidence of errors and bulk. ELEMENTS OF FINANCIAL STATEMENTS Financial Position In simple terms, assets are valuable resources owned by the entity. Per Framework, asset is a resource controlled by the enterprise as a,result of past events and from which future economic benefits are expected to flow to the enterprise. The future economic benefits embodied in an asset may flow to the enterprise in a number of ways. The parts of the definition of an asset can be explained further: * “Controlled by the enterprise” — Control is the ability to obtain the economic benefits and to restrict the access of others (e.g. an entity being the sole user.of its plant and equipment, or by selling idle assets). ¢* “Past events” —- The event must be past before an asset can arise. For example, equipment will only become an asset when there is the right to demand delivery or access to the asset's potential. Dependent on the terms of the contract, this may be ‘on acceptance of the order or on delivery. « “Future economic benefits” — These are evidenced by the prospective receipt of cash, This could be cash itself, an account receivable or any item which may be sold. Although, for example, a factory may not be sold (on a going concern basis) for it houses the manufacturing facility for the goods. When these goods are sold, the economic benefit resulting from the use of the factory is realized as cash.3-8 | Basie Accounting s . For example, an asset may.be: + Used singly or In combination with other assets In the production of goods or “ gervices to be sold by the enterprise; + Exchanged for other assets; + Used to settle a lability; or © Distributed to the owners of the enterprise. Assets Include cash, cash equivalents, notes recelvable, accounts receivable, Inventories, prepaid expenses, property, plant and equipment, Investments, Intangible assets and other assets, Liabilities are obligations of the entity to outside parties who have furnished resources. Per Framework, Hlability Is a present obligation of the enterprise arising from past ‘events, the settlement of which Is expected to result in an outflow from the enterprise ‘of resources embodying economic benefits. The parts of the definition of a liability can be explained further: © “Obligations” ~ These may be legal or not. For example, the year end tax lability relates to the year’s (i.e. past) events but in law this llability does not arise until it is assessed some time later. ‘© “Transfer economic benefits” - This could be a transfer of cash, or other property, the provision of a service or the refraining from activities which would otherwise be profitable. 7 “Past transactions or events” ~ refer to discussion In assets, “Complementary nature of assets and llabllities” - As should be evident from the above, assets and liabilities are seen as mirror images of each other. Settlement of a present obligation may occur in a number of ways, for example, by: + Payment of cash; + Transfer of other assets; + Provision of services; + Replacement of that obligation with another obligation; or + Conversion of the obligation to equity. Liabilities include notes payable, accounts payable, accrued liabilities, unearned revenues, mortgage payable, bonds payable and other debts of the enterprise. Equity is the residual interest in the assets of the enterprise after deducting all its Habilities, Equity may pertain to any of the following depending on the form of business organization:The Accounting Equation and the Double Entry System | 3-9 + Ina sole proprietorship, there Is only one owner's equity account because there is only one owner. + Ina partnership, an owner’s equity account exists for each partner, + In a corporation, owners’ equity of stockholders’ equity consists of share capital, retained earnings and reserves representing appropriations of retained earnings among others. Performance Income is increases in economic benefits during the accounting period in the form of inflows or enhancements of assets or decreases of liabilities that result in increases in equity, other than those relating to contributions from equity participants. ‘The definition of income encompasses both revenue and gains. Revenue arises in the course of the ordinary activities of an enterprise and is referred to by a variety of different names including sales, fees, interest, dividends, royalties, and rent. Gains represent other items that meet the definition of income and may, or may not, arise in the course of the ordinary activities of an enterprise. Gains represent increases in economic benefits and as such are no different in nature from revenue. Hence, they are not regarded as constituting a separate element. Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of assets or incurrences of liabilities that result in decreases in equity, other than those relating to distributions to equity participants. ‘The definition of expenses encompasses losses as well as those expenses that arise in the course of the ordinary activities of the enterprise. There are various classes of expenses but they are generally classified as cost of services rendered or goods sold, distribution or selling expenses, administrative expenses or other operating expenses. Losses represent other items that meet the definition of expense and may or may not, arise in the course of the ordinary activities of an enterprise. Losses represent decreases in economic benefits and as such are no different in nature from other expenses. Hence, they are not regarded as a separate element in this framework. THE ACCOUNT The basic summary device of accounting Is the account.. A separate account is maintained for each element that appears in the balance sheet (assets, liabilities and equity) and In the income statement (income and expenses). Thus, an account may be defined as a detailed record of the Increases, decreases and balance of each element that appears in an entity's financial atatements,{ The simplest form of the account is known as the “T” account because of Its similarity to the letter "T", The account has three parts as shown next page:3-10 | Basic Accounting es Account Title Left side or |: Right side or Debit side | Credit side THE ACCOUNTING EQUATION Financial statements tell us how a business is performing. They are the final products of the accounting process. But how do We arrive at the items and amounts that make up the financial statements? ‘The most basic tool of accounting is the accounting equation. / This equation presents the resources controlled by the enterprise, the present obligations of the enterprise and the residual interest in the assets./it states that assets must always equal liabilities and owner's equity.’ The basic accounting model is: Assets = Liabilities + Owner's Equity Note that the assets are on the left side of the equation opposite the liabilities and owner's equity. This explains why increases and decreases in assets are recorded in the opposite manner (“mirror image”) as liabilities and owner's equity are recorded. The equation also explains why liabilities and owner's equity follow the same rules of debit and credit. The logic of debiting and crediting is related to the accounting equation. Transactions may require additions to both sides (left and right sides), subtractions from both sides (left and right sides), or an addition and subtraction on the same side (left or right side), but in all cases the equality must be maintained as shown below: Owner's Assets Uabllities Equity u +the Accounting uration wn the Double etey bate $4 DEBITS AND CREDITS~THE DOUBLE-ENTRY SYSTEM Accounting is based of a double-entry systern whieh means that the dul affects of & business transaction is recotded./ A debit side entry must have a Corteapianlivng Crudit side entry. For every transaction, there must be one oF mure acequnite debited and ane ‘or more accounts credited, Each transaction affects at least (wer accounts, Thee total debits for a transaction must always equal the (otal credits, An account is debited when an amount Is entered on the left siete of the accent avid credited when an amount Is entered on the right side, The abbreviations for datit and credit are Dr, (from the Latin debere) and Cr. (fram the Latin credere), reapectivaty, ‘The account type determines how increases of decreases in it are recorded. Increases in assets are recorded as debits (on the left side of the account) while decreases in assets are recorded as credits (an the right side), Conversely, Increases in liabilities and owner's equity are recorded by credits and decreases are entered as debits, ‘The rules of debit and credit for income and expense accounts are based on the relationship of these accounts to owner's equity. Income increases owner's equity and expense decreases owner's equity, Hence, increases in income are recorded as credits and decreases as debits. Increases in expenses are recorded as debits and decreases as credits. These are the rules of debit and credit./'The following summarizes the rules: Balance Sheet Accounts Assets abilities and Owner's Equity Debit Debit { 0 | | a ) { Increases Decreases Decreases Increases Normal Balance Normal Balance Income Statement Accounts Debit for decreases in owner's equity Expenses Credit for increases in owner's equity Credit Debit: fi | | a «4 { Decreases Decreases Increases Debit t ) Increases ‘Normol Balance@ l 3-12 | Basic Accounting SS el 3 ‘NORMAL BALANCE OF AN ACCOUNT ‘The normal balance of any account refers to the side of the account—debit or credit— where increases are recotded. Asset, owner's withdrawal and expense accounts normally have debit balances; liability, owner's equity and income accounts normally - have credit balances. This result occurs because increases in an account. are usually — greater than or equal to decreases. Tnereases Recorded by Worrel Batons. ‘Recount Category Debit Credit Debit__[ Credit Assets « v Uabilties v ce ‘Owner's Equity: (Owner's Capital 7 ~ Withdrawals v ~ Tncome v Ss Expenses z v ACCOUNTING EVENTS AND TRANSACTIONS An accounting event is an economic occurrence that causes changes in an enterprise’s assets, liabilities, and/or equity. Events may be internal actions, such as the use of equipment for the production of goods or services. It can also be an external event, such as the purchase of raw materials from a supplier. A transaction is a particular kind of event that involves the transfer of something of value between two entities. Examples of transactions include acquiring assets from owner(s), borrowing funds from creditors, and purchasing or selling goods and services. TYPES AND EFFECTS OF TRANSACTIONS tt will be beneficial in the long-term to be able to. understand a classification approach that emphasizes the effects of accounting events rather than the recording procedures. involved. This approach is quite pioneering. Although business entities engage in numerous transactions, all transactions can be classified into one of four types, namely: 1. Source of Assets (SA). An asset account increases and a corresponding claims (iabilties or owner's equity) account increases. Examples: (1) Purchase of supplies, ‘on account; (2} Sold goods on cash on delivery basis, ° . Exchange of Assets (EA), One asset account increases and another asset account decreases. Example: Acquired equipment for cash.Lie Accounting Fyuation aid pi tee sytem 319 A. Use of Assets (UA) An mavet nernunt decreas and a corresponding dame (Viatsilitien ar equity) account deerwases, Franngile, (1) Gettled accounts payabhe; (7) Patd salaries of employers, 4. Exchange of Claims (EC). One claims (liabilities af owner's equity) account increases and another clamp (iabilitios or owner's equity) account decreases, trample: Received utilities bill but did not pay, Every accountable event has a dual but self-balancing effact on the accounting equation, Recognizing th events will not In any manner affact the equality of the basic accounting model, The four types of transactions above may be further expanded into nine types of effects as follows; 1, Increase In Assets + Increase [n Liabilities (SA) 2. Increase In Assets # Increase In Owner's Equity (5A) 3, Increase In one Asset « Decrease in another Asset (BA) 4 S. Decrease In Assets # Decrease In Llabilithes (UA) Decrease In Assets = Decrease In Owner's Equity (UA) Increase In Liabilities = Decrease in Owner's Equity (EC) tncrease In Owner’s Equity « Decroase In Liabilities (Cc) Increase In one Liability = Decrease In another Liability (EC) Increase In one Owner's Equity # Decrease In another Owner's Equity (EC) yan TYPICAL ACCOUNT TITLES USED STATEMENT OF FINANCIAL POSITION Assets Assets are should be classifled only Into two: current assets and non-current assets. Per revised Philippine Accounting Standards (PAS) No. 1, an entity shall classify assets as current when: a. it expects to realize the asset, or Intends to sell or consume It, in its normal. operating cycle; b. itholds the asset primarily for the purpose of trading; ¢. it expects to realize the asset within twelve months after the reporting period; or d. the asset Is cash or a cash equivalent (as defined \n'PAS No. 7) unless the asset Is restricted from being exchanged or used to settle a liability for at Jeast twelve months after the reporting perlod, All other assets should be classified as non-current assets, Operating cycle Is the time between the acquisition of, assets. for.processing and thelr realization in cash or cash equivalents, When the entity’s normal operating cycle Is not clearly identifiable, it is | assumed to be twelve months,Current Assets oe Cash. Cash is any medium of exchange that a bank will accept for deposit at face value. It includes coins, currency, checks, money orders, bank deposits arid drafts: ; ‘Cash Equivalents, Per PAS No. 7, these afe short-term, highly liquid investments that are readily convertible to known amounts of cash and which are subject to an” Insignificant risk of changes In value, Notes Receivable. A note receivable is a written pledge that the customer will pay the business a fixed amount of money on a certain date, Accounts Receivable, These are claims against customers arising from sale of services ‘or goods on credit. This type of receivable offers less security than a promissory note. Inventories. Per PAS No. 2, these are assets which are (a) held for sale in the ordinary course of business; (b) in the process of production for such sale; or (c) in the form of materials or supplies to be consumed in the production process or in the rendering of services. Prepaid Expenses. These are expenses paid for by the business in advance. It is a asset because the business avoids having to pay cash in the future for 2 specific expense. These include insurance and rent. These prepaid items represent future economic benefits—assets—until the time these start to contribute to the earning process; these, then, become expenses. Non-current Assets Property, Plant and Equipment. Per PAS No. 16, these are tangible assets that are held by an enterprise for use in the production or supply of goods or services, or for remtal tz others, or for administrative purposes and which are expected to be used during mrar= than one period. Included are such items as land, building, machinery and equipment. furniture and fixtures, motor vehicles and equipment. Accumulated Depreciation. jIt Is @ contra account that contains the sum of the periodic depreciation charges. The balance in this account Is deducted from the cost of the related asset-—equipment or bulldings—to obtain book value, intangible Assets, Per PAS No. 38, these are Identifiable, nonmonetary assets without physical substance held for use In the production or supply of goods oF services, for rental to others, or for administrative purposes, These include goodwill, patests. copyrights, licenses, franchises, trademarks, brand names, secret processes. subscription lists and non-competition agreements. Uabilitles Per revised Philippine Accounting Standards (PAS) No, 1, an ent classify a tabi as current when: : etal :i ' K b i ke I I The Accounting Equation and the Double Entry System | 3-15 it expects to settle the liability in its normal operating cycle; 'b. itholds the liability primarily for the purpose of trading; ‘c. the liability is due to be settled within twelve months after the reporting period; or d. the entity does not have an unconditional right to defer settlement of the liability for at least twelve months after the reporting period. Au! other lial s should be classified as non-current liabilities. Current Liabilities Accounts Payable. This account represents the reverse relationship of the accounts yetevable. By accepting the goods or services, the buyer agrees to pay for them in the ser future. Notes Payable. A note payable is like a note receivable but in a reverse sense. In the czse of a note payable, the business entity is the maker of the note; that is, the business entity is the party who promises to pay the other party a specified amount of money on 2 specified future date. Accrued Liabilities. Amounts owed to others for unpaid expenses. This account includes salaries payable, utilities payable, interest payable and taxes payable. ned Revenues. When the business entity receives payment before providing its tomers with goods or services, the amounts received are recorded in the unearned account (liability method): When the goods or services are provided to the tomer, the unearned revenue is reduced and income is recognized. rev Current Portion of Long-Term Debt. These are portions of mortgage notes, bonds and ver long-term indebtedness which are to be paid within one year fram the balance neet date i on ‘son-current Liabilities thortgage Payable. This account records long-term debt of ‘the business entity for which the business entity has pledged certain assets as security to the creditor. In the event that the debt payments are not made, the creditor can foreclose or cause the’ mortgaged asset to be sold to enable the entity to settle the claim, Bonds Payable. Business organizations often obtain substantial sums of money from Jenders to finance the acquisition of equipment and other needed assets.. They obtain thete funds by issuing bonds. The bond Is a contract between the issuer and the lender specifying the terms of repayment and the interest to be charged.3-16 | Basic Accounting ‘Owner's Equity Capital (from the Latin copitalis, meaning “property’). This account is used to record the original and additional investments of the owner of the business entity. It is increased by the amount of profit earned during the year or Is decreased by aloss. Cash or other assets that the owner may withdraw from the business ultimately reduce it, This account title bears the name of the owner, Withdrawals. When the owner of a business entity withdraws cash or other assets, such are recorded In the drawing or withdrawal account rather than directly reducing the owner's equity account. Income Summary. It is a temporary account used at the end of the accounting period to close income and expenses. This account shows the profit or loss for the period before closing to the capital account. INCOME STATEMENT Income Service Income. Revenues earned by performing services for a customer or client; for example, accounting services by a GPA firm, laundry services by a laundry shop. Sales. Revenues earned as a result of sale of merchandise; for example, sale of building materials by a construction supplies firm. Expenses Cost of Sales. The cost incurred to purchase or to produce the products sold to customers during the period; also called cost of goods sold. Salaries or Wages Expense. Includes all payments as a result of an employer-employee relationship such as salaries or wages, 13” month pay, cost of living allowances and other related benefits, Telecommunications, Electricity, Fuel and Water Expenses. Expenses related to use of telecommunications facilities, consumption of electricity, fuel and water. Rent Expense. Expense for space, equipment or other asset rentals. Supplies Expense. Expense of using supplies (e.g. office supplies) in the conduct of daity ° business. Insurance Expense. Portion of premiums pald on insurance coverage (e.g. on motor vehicle, health, life, fire, typhoon or flood) which has expired. Depreciation Expense. The portion of the cost of a tangible asset (e.g. buildings and equipment) allocated or charged as expense during an accounting period. Uncollectible Accounts Expense. The amount of receivables estimated to be doubtful | of collection and charged as expense during an accounting period, Interest Expense. An expense related to use of borrowed funds,The Accounting Equation and the Double Entry System | 3-17 ACCOUNTING FOR BUSINESS TRANSACTIONS Accountants observe many events that they identify and measure in financial terms. A business transaction is the occurrence of an event or a condition that affects financial position and can be reliably recorded. Financial Transaction Worksheet Every financial transaction can be analyzed or expressed In terms of its effects on the accounting equation. The financial transactions will be analyzed by means of a financial transaction worksheet which Is a form used to analyze increases and decreases in the assets, liabilities or owner's equity of a business entity. Mustration, Edgar Detoya decided to establish a sole proprietorship business and named it as Detoya Graphics Design. Detoya is a graphic designer who has extensive experience in drawing, layout, typography, lettering, diagramming and photography. He possesses the talent to visually communicate to a target audience with the right combination of words, images and ideas. : Detoya Graphics Design can do the layout and production design of newspapers, magazines, corporate reports, journals and other publications. The entity can create promotional displays; marketing brochures for.services and products; packaging design for products; and distinctive logos for businesses. He also enters into agreements with clients for the progressive development and maintenance of their web sites. His initial Tevenue stream comes from web designing. The owner, Edgar Detoya, makes the business decisions, The assets of the company belong to Detoya and all obligations of the business are his responsibility. Any income that the entity earns belongs solely to Detoya. When a specific asset, liability or owner's equity item is created by a financial transaction, it is listed in the financial transaction worksheet using the appropriate accounts. The worksheet that follows shows the first transaction of the Detoya Graphics Design. The dates are enclosed in parentheses. During March 2014, the first month of operations, various financial transactions took place. These transactions are described and analyzed as follows: Mar.1 —Detoya started his new business by depositing P350,000 in a bank account in the name of Detoya Graphics Design at BP! Poblacion Branch,2 Bash ACCU Detoya Graphics Design Financial Transaction Worksheet Month of March 2014 Assets . Usbllities. + Owner's Equity e Cash . Detoya, Capital w 350,000 * 350,000 The financial transaction is analyzed as follows: + Anentity separate and distinct from Detoya’s personal financial affairs is created. + An economic resource—cash of P350,000 is invested in the business entity. The source of this asset Is the contribution made by the owner, which represents ‘owner's equity. The owner's equity account is Detoya, Capital. «The dual nature of the transaction is that cash is invested and owner's equity created. The effects on the accounting equation are as follows: increase in asset— cash from zero to P350,000 and increase in owner's equity from zero to P350,000. ¢ Atthis point, the entity has no liabilities, and assets equal owner’s equity. Mar.5 Computer equipment costing P145,000 is acquired on cash basis. The effect of the transaction on the basic equation is: Assets = Liabilities + Owner's Equity Gash + Computer = Detoya, Capital Equipment Bal. 350,000 = 350,000 (5) _ (245,000) 145,000. = Bal, 7205000, + P145,000_ = P350,000 . 350,000 P350,000 This transaction did not change the total assets but it did change the composition of the assets—it decreased one asset—cash and increased another asset—computer equipment by P145,000, Note that the sums of the balances on both sides of the equation are equal. This equality must always exist, Mar,9 — Computer supplies In the amount of P25,000 are purchased on account. Assets ‘ = Uabilties + Owner's Equity Cash = + “Computer + Computer = Accounts Supplies Equipment fee ee Bal, 205,000 P145,000 = 7 perio ene ee ay » 28000 350,000 fl, ~ 205,000 + 25,000 Faso | Bee ee enna a * ee P 2s, T7000". ee’ P850,000, P es 375,000ee The Accounting Equation and the Double Entry System | 3-19 Assets don’t have to be purchased In cash. It can also be purchased on credit. Acquiring the computer supplies with a promise to pay the amount due later is called buying on account. This transaction increases both the assets and the liabilities of the business. ‘The asset affected is computer supplies and the liability created is an accounts payable. Mar. 11 Detoya Graphics Design collected P88,000 in cash for designing interactive S y web sites for two exporters based inside the Naga Ecozone. Assets = Uabllities + — Owner's Equity Cash + Computer + Computer = Accounts: + — Detoya, Capital ‘Supplies Equipment Payable Bal. P205,000 25,000 P145,000 = 25,000 350,000 (11) __88,000 : £8,000 Bal, _ P293,000 + P25,000-+ _P145,000_ = P25,000_ + P438,000 463,000. = P463,000 The entity earned service income by designing web sites for clients. Detoya rendered his professional services and collected revenues in cash. The effect on the accounting equation is an increase in the asset—cash and an increase in owner’s equity. Income increases owner's equity. This transaction caused the business to grow, as shown by the increase in total assets from P375,000 to P463,000. Mar. 16 Detoya paid P18,000 to Bills Express, a one-stop bills payment service company, for the semi-monthly utilities. Assets = Labllities + + Owner's Equity Cash + Computer + Computer = Accounts + -—_—Detoya, Capital Supplies Equipment: Payable Bal. —-P293,000 25,000 145,000 = 25,000 433,000 (16) __ (18,000) See 128,000) Bal. _?275,000_ +” 25000 + P145,000_ = 735,000. + $430,000 445,000 = 445,000, Expenses are recorded when they are Incurred. Expenses.can be pald In cash when they ‘occur, or they can be pald later, The payment for utilities is an expense for the month of March. It represented an outflow of resources and a reduction of owner's equity. Expenses have the opposite effect of Income; they cause the business to shrink as shown by the smaller amount of total assets of P445,000, Mar. 17 The entity has service agreements with several Netpreneurs to maintain and update their web sites weekly, Dataya billed these clients P35,000 for services already rendered during the month,3-20 | Basic Accounting Ee en rr ent arent nen en aac A = L 4-5: OF: Cash + Accounts + Computer + Computer = Accounts + Detoya, ; Rocelvable Supplies. Equipment Payable Bal. —P275,000 P25,000 145,000 . 25,000 P420,000 (17) P35,000 . 35, Bal. 275,000, + 35,000 + 25,000 + P145,000. = 25,000 + LE P480,000_ = _P480,000_ The entity has performed services to clients so income should already be recognized, Detoya is entitled to receive payment for these but the clients did not pay immediately, Performing the services creates an economic resource, the clients’ promise to pay the amount which is called accounts receivable. This transaction resulted to an increase in an asset—accounts receivable and an increase in owner's equity of P35,000. Mar. 19 Detoya made a partial payment of P17,000 for the Mar. 9 purchase on account. A a bE ey OE Cash + Accounts + Computer + Computer = Accounts + Detoya, Receivable Supplies Equipment Payable Capitat Bal. —P275,000 35,000 25,000 P145,000 = 25,000 P455,000 (19) __(17,000) = __ (17,000) : Bal. __P258,000_ + P35,000 + P25,000 + _P145,000 = P8000. + P455,000 463,000. = _P463,000 This transaction is a payment on account. The effect on the accounting equation is a decrease in the asset—cash and a decrease in the liability—accounts payable. The payment of cash on account has no effect on the asset-—computer supplies because the payment does not increase or decrease the supplies available to the business. Mar. 20 Checks totaling P25,000 were received from clients for billings dated Mar. 17. i : tf A = L + OE Cash + Accounts. «+ Computer + Computer = Accounts + - Detoya, Receivable ‘Supplies Equipment Payable Capital Bal. 258,000 35,000 25,000 145,000 =, P8,000 455,000 (20) __25,000 (25,000) = Bal, __P283,000_ + P1000 + ___P25,000_ + P:145,000_ = ___P&,000_ + __ P45S,000 463,000 =. P463,000 Last Mar. 17, Detoya billed clients for services already rendered. On Mar. 20, the entity was able to collect P25,000 from them, The asset~cash is increased by P25,000.. The business should not record service Income on Mar. 20 since it has already recorded theThe Accounting Equation and the Double Entry System | 3-21 income last Mar. 17. Total assets are unchanged. The business merely reduced one asset—accounts receivable and Increased another—cash. Mar. 21 Detoya withdrew P20,000 from the business for his personal use. a) A 2 Ces 0k Cash + Atcounts + Computer + Computer = Accounts + Detoya, Recelvable Supplies Equipment Payable Capital Bal. P283,000 P10,000 25,000 P145000 = ——P8,000 455,000 (21) __(20,000)_ : (20,000) Bal. __P263,000_ + P10,000_ +” P2500 + _P145,000 = __P8,000_ + P435,000 P443,000_ = __P443,000 Withdrawal of cash or other assets for personal use is the way by which the owner of the entity receives advance distribution of the profits. On Mar. 1, Detoya invested 350,000; both cash and owner’s equity increased. The transaction was an investment by the owner and not an income-generating activity. Detoya simply transferred funds from his personal account to the business. A cash withdrawal is exactly the opposite. The P20,000 cash withdrawal transaction resulted to a reduction in both cash and owner’s equity. Mar. 27. Edman Flores Publishing submitted a bill to Detoya for P8,000 worth of newspaper advertisements for this.month. Detoya will pay this bill next ~~ month. A = L + OE Cash + Accounts. © + Computer + Computer = Accounts + Detoya, Receivable Supplies Equipment Payable Capital Bal. 263,000 10,000 P2so00 * P145,000 = P8000 435,000 (27) = 8,000 (8,000) Bal. __ P263,000 + P10,000 + _P25,000 + _ P145,000 P16,000_ + P427,000 roan” - Teagan Edman Flores rendered services on account. Detoya Graphics Design has incurred an expense in the amount of PB,000 by availing of Edman Flores’ services. There was no payment during the month, This advertising expense resulted to a decrease in owner's equity and an increase In the llabllity—accounts payable. Mar, Me Detoya pald his assistant designer salarles of P15,000 for the month. UF :322 |. Basic Accounting r aaa = A we bee AY OF Cash + Accounts + ‘Computer + Computer = Accounts + -Detoya, Recelvable Supplies Equipment Payable Capital Bal. 263,000 10,000 25,000 145,000 = —P16,000 Pad (28) __(35,000), = (15,000) _ Bal, _P248,000_ + __Pi0,000_ +" 625,000. +__P145,000_ = _P16000_ + __P412,000 eS ee 428,000 :. 428,000 This transaction resulted to a reduction in owner's equity as well as a reduction in cash. By providing his services to Detoya for the month, the assistant designer has created for the business an expense—salaries expense. Use of T-Accounts Analyzing and recording transactions using the accounting equation is useful in conveying a basic understanding of how transactions affect the business. However, it is not an efficient approach once the number of accounts involved increases. Double- entry system provides a formal system of classification and recording business transactions. Ilustration. The rules of debit and credit will be applied to the Detoya Graphics Design illustration for comparison. Three transactions will be added to the.example. Before being recorded, a transaction must be analyzed to determine which accounts must be increased or decreased. After this has been determined, the rules of debit and credit are applied to effect the appropriate increases and decreases to the accounts. Mar. 1 Detoya started his new business by depositing P350,000 in a bank account in the name of Detoya Graphics Design at BPI Poblacion Branch. Assets (Increase) = ‘Owner's Equity (Increase) Cash : Detoya, Capital Debit Credit Debit Credit (*) Oe i) ty) 3-1 350,000 3-1 350,000 This transaction increased both the asset—cash and owner's equity. According to the rules of debit and credit, an increase In asset is recorded as debit while an increase in owner's equity is recorded as credit; thus, the entry Is to debit cash and to credit Detoya, Capital; The transaction dates are placed on the left side of the amounts for reference. Mar.2 Computer equipment is acquired by Issuing a P50,000 note payable to Rosemarie Jacalan Office Systems. The note Is due in six months.The Accounting Equation and the Double Entry System | 3-23 Assets (Increase) = abilities (Increase) Computer Equipment Notes Payable Debit Credit Debit Credit (*) i) 0 (+) 32 50,000 32 50,000 The transaction increased by P50,000 the asset—computer equipment and the liability—notes payable. Computer equipment must be debited and notes payable must be credited. Mar. 3 Detoya paid P15,000 to Grande Suites for rent on the office studio for the months of March, April and May. Assets (Decrease) = Assets (Increase) Cash Prepaid Rent Debit Credit Debit Credit Se) a (+) O 31 350,000 | 3-3 15,000 33 15,000 The entity paid advance rent for three months. A resource having future: economic benefit—prepaid rent, is acquired for a cash payment of P15,000. Increases in assets are recorded by debits and decreases in assets are recorded by credits. The transaction resulted to a debit to prepaid rent and a credit to cash for P15,000. The prepaid rent is consumed based on the passage of time so that after one month, P5,000 of the prepaid rent will be transferred to the rent expense account. Mar.4 Received advance payment of P18,000 from Marco Polo Naga Hotel for web site updating for the next three months. Assets (Increase) = Uabilities (Increase) Cash Unearned Revenues Debit Credit Debit Credit ) iC) 0 ) 34 350,000 | 3-3 15,000 4 18,000 3-4 18,000 The entity has an obligation to Marco Polo Naga Hotel for the next three months, This liability is called unearned revenues. The asset—cash is increased by a debit of P18,000 and the liability~-unearned revenues Is Increased by a credit of P18,000. As it renders service, the entity discharges Its obligation at a rate of P6,000 per month for the next three months.4h 1, 3-24 | Basic Accounting: . cciasetceiaaamaattia Mar.5 Computer equipment costing P145,000 is acquired on cash basis. Assets (Decrease) . ‘Assets (Increase) Cash Computer Equipment. Debit Credit Debit Credit ) 0 (+) 0 31 350,000 | 3-3 15,000 32 50,000 34 18,000 | 3-5 145,000 35 145,000 This transaction increased the asset—computer equipment and decreased the asset— cash. Assets are increased by debits and decreased by credits; thus, computer ‘equipment is debited and cash is credited for P145,000. Mar. Computer supplies in the amount of P25,000 are purchased on account. Assets (Increase) ‘se abilities (Increase) Computer Supplies Accounts Payable Debit Credit Debit Credit 4) Q Q i) 38 25,000 39 25,000 The asset—computer supplies is increased by a debit of P25,000 while the liability ‘account—accounts payable is increased by a credit for the same amount. Mar. 11 Detoya Graphics Design collected P88,000 in cash for designing web sites. Assets (Increase) = ‘Owner's Equity (Increase) Cash Design Revenues Debit Credit Debit Credit (+) 0) 0 (+) 31 350,000 | 3-3 15,000 3-11 88,000 34 18,000 | 3-5 145,000 241 88,000 The transaction increased the asset—cash and increased the income account—design revenues, Assets are increased by debits, income are increased by credits; hence, a debit of P88,000 to cash and a credit of P88,000 to design revenues is made. Increases in income increase owner's equity, Mar. 16 Detoya paid P18,000 ta Bills Express for the semi-monthly utilities.The Accounting Equation and the Double Entry System | 3-25 Assets (Decrease) = ‘Owner's Equity (Decrease) Cash Utilities Expense = Debit Credit Debit Credit - (4) a ) O 31 350,000 | 3-3 15,000 3:16 18,000 34 18,000 | 3-5 145,000 3-11 88,000 | 3-16 18,000 Expenses are increased by debits and assets are decreased by credits; therefore, utilities expense is debited and cash credited for P18,000. Increases in expenses decrease owner's equity. Mar. 17 Detoya billed clients P35,000 for services already rendered during the month. Assets (Increase) = Owner's Equity (Increase) Accounts Receivable Design Revenues Debit Credit Debit Credit (+) O a (+ 3-417 35,000 3-11 88,000 3-17 35,000 Assets are increased by debits, income are increased by credits. Increases in income increase owner's equity. A debit of P35,000 to accounts receivable and a credit of 35,000 to the income account—design revenues is needed. Mar. 19 Detoya partially paid P17,000 for the Mar. 9 purchase of computer supplies. Assets (Decrease) = Uabilities (Decrease) Cash Accounts Payable Debit Credit Debit Credit (+) a a (*) 3-1 350,000 | 3-3 15,000 319 17,000 | 3-9 25,000 3-4 18,000] 3-5 _ 145,000 311 88,000 | 3-16 18,000 3-19 17,000 Assets are decreased by credits while liabilities are decreased by debits. The transaction is recorded by debiting accounts payable and crediting cash for P17,000 each.3-26 | Basic Accounting f Mar. 20. Received checks totaling P25,000 from clients for billings dated Mar. 17. Assets (Increase) . Assets (Decrease) Cash Accounts Receivable Debit Credit Debit Credit * ) (+) 0 3-1 350,000 | 3-3 15,000 3-17 35,000 | 3-20 25,000 34 18,000 | 3-5 145,000 3-11 88,000] 3-16 18,000 3:20 25,000] 3-19 17,000 Collections on account. reduced the asset—accounts receivable but increased the asset—cash. Assets are increased by debits and decreased by credits; thus, a. debit to cash for P25,000 and a credit to accounts receivable for P25,000 is made. Mar. 21 Detoya withdrew P20,000 from the business for his personal use. Assets (Decrease) = ‘Owner's Equity (Decrease) Cash Detoya, Withdrawals Debit Credit Debit Credit ) a Co) 0 31 350,000 | 3-3 15,000 3-21 20,000 34 18,000 | 3-5 145,000 341 88,000 | 3-16 18,000 3-20 25,000 | 3-19 17,000 3-21 20,000 Withdrawals are reductions of owner's equity but are not expenses of the business entity. A withdrawal is a personal transaction of the owner that is exactly the opposite of an investment. This transaction increased the withdrawals account but reduced cash. Debits record increases in the withdrawals account and credits record decreases in asset accounts; thus, a debit to withdrawals and a credit to cash for P20,000 each is necessary. Mar. 27 Edman Flores billed Detoya for P8,000 ads, Detoya will pay next month. Liabilities (Increase) ® Owner's Equity (Decrease) Accounts Payable Advertising Expense Debit Credit Debit Credit 0 4 () ri 3-19 17,000 | 3-9 25,000 3-27 8,000 327 8,000The Accounting Equation and the Double Entry System | 3-27 This transaction Increased the expense—advertising expense and increased the liability—accounts payable by P8,000. Expenses are increased by debits while liabilities are Increased by credits; hence, an entry. to debit advertising expense and to credit accounts payable for P8,000 is needed. Mar. 31 Detoya paid his assistant designer salaries of P15,000 for the month. Assets (Decrease) . Owner's Equity (Decrease) Cash Salarles Expense Debit Credit Debit Credit Ne) ) (+) 0 3-1 350,000 | 3-3 15,000 331 15,000 34 18,000 | 3-5 145,000 3-11 88,000 | 3-16 18,000 3-20 25,000 | 3-19 17,000 3-21 20,000 3-31 15,000 Expenses are increased by debits and assets are decreased by credits. Hence, salaries” expense is debited for P15,000 and cash credited for the same amount. Increases in salaries expense decrease owner's equity. DISTINCTION BETWEEN REVENUES AND RECEIPTS At this point, it will be useful to learn the distinction between revenues and receipts as illustrated in the following table. The table shows various types of sales transactions and classifies the effect of each on cash receipts and sales revenues for “this year”: This Year Transaction ‘Amount Cash Sales Receipts Revenue 1. Cash sales made this year, 200,000 200,000 ——-P200,000 2. Credit sales made last year; 300,000 300,000 0 cash received this year, 3. Credit sales made this year; 400,000 400,000 400,000 cash received this year, 4, Credit sales made this year; 100,000 0 100,000 cash to be recelved next year, s Total P900,000 £700,000,Table of Contents Preface... Acknowledgment ... CHAPTER 1 CHAPTER 2 Management Accounting. Management... Basic Functions of Management. Management by Objective: Management by Exception Management Accounting .. Management Accounting vs. Financial Accounting, Summary of Differences: .. ‘The Controller: Chief Management Accountant. Controllership Controller Controller vs. Treasurer Line Function vs. Staff Functioy Standards of Ethical Conduct for Management Accountants Exercises..... Cost Concepts and Cost Behavior Analysis... Cost Defined.. Cost of Sales, Operating Expenses and Losses. Different Costs for Different Purposes (Classifications of Costs).CHAPTER 4 CHAPTER 5 Cost Behavior... Cost Behavior Assumptions. - Cost Estimation: Segregation of Mixe and Variable Elements a4 Equation “Y =a + bX” 24 High-Low Method... 21 Least-Squares Method. uy Scattergraph (Scatter Diagram) Method .. 2 Engineering Method... 30 Account Analysis Method 30 Conference Method. 30 Exercise! 3 Cost Accounting Cycle 49 Cost Accounting . 49 ‘Types of Manufatturing Costs: 50 Prime Cost 50 Conversion Cost... 0 Inventories for a Manufacturing Company. 51 Systems of Cost Accumulation... 31 Recording Transactions of a Manufacturing Company 2 Over and Under-applied Factory Overhead... 5 Pro-forma entries for closing over or under-applied factory overhead: 5 Exercises... 6 Cost-Volume-Profit and Break-Even Analysis.......... B Cost-Volume-Profit (CVP) Analysi ; B Contribution Margin (CM), 76 Break-Even Point (BEP). 76 Margin of Safety (MS). B Indifference Point....... 80 Sales Mi 8 Degree of Operating Leverage 86 Exercises 89 Absorption and Variable Costing .....sssesssssssscssseccssstesseenessees 105 Absorption Costing, Product/Inventory Cost per unit Computatio: ‘Total Inventory Cost Computatio: Variable Costing... Product/Inventory Cost per unit Computatio: ‘Total Inventory Cost Computation Profit/Loss Computations Compariso:CHAPTER 6 CHAPTER 7 CHAPTER 8 CHAPTER 9 Supporting computations/discussions: 108 Advantages of Using Variable Costing: 108 Disadvantages of Using Variable Costin, 108 Product Cost vs. Period Cos! 109 Reconciliation of Income under Absorption and Variable Costing 109 Exercises, 115 Financial Statement Analysis 127 Financial Statement Analysis . 127 Three basic tools of Financial Statement Analysis: 127 Horizontal Analysi 128 Exercises... 139 Budgeting........ Budget, defined Uses of Budgeting Limitations of Budgeting Master Budget... Operating Budget. Financial Budge Appropriation-type budget. Budgeting-Related Terminologies:. Benefits of a well-prepared budget: 155 Exercises... 163 Responsibility Accounting ... 177 Responsibility Accounting... 177 Steps in Implementing Responsil 178 Economic value added (EVA) 180 Service Costs Allocation... 183 Service Costs Allocation Methods: 183 186 186 Potential advantages of decentralization: 187 Potential disadvantages of decentralizatio 187 Exercises. 189 Transfer Pricing « cansseeseeaseasenenens 205 Transfer Price .. 205CHAPTER 10 Basis of Transfer Price. Maximum vs. Minimum Transfer Prices (Upper Limit , as . vs. Lower Limit). * xercises. x Activity-Based Costing ..... Activity-Based Costing (ABC), ABC vs. TRADITIONAL COSTIN' 223 STEPS IN IMPLEMENTING AB‘ 224° Summary of ABC application: 227 Exercises.CHAPTER 1 Management Accounting Learning Objectives At the end of the chapter, the learner should be able to: Enumerate and discuss the differences between financial and management accounting. Discuss the role of managerial accounting in a business. Enumerate the various uses of managerial accounting information. Differentiate the functions of Controller and Treasurer in an organization. Discuss the differences between staff and line functions. Explain the ethical standards for management accountants. &N SAAS Management Management is the process of planning, organizing, and controlling a certain task to realize the objectives of the organization. Basic Functions of Management Planning Planning involves setting immediate and long-term objectives and deciding which alternative is best suited to attain the set objectives, :An important part of planning is to identify alternatives and then to select from among the alternatives the one that does the best job of furthering the organization's objectives, Once alternatives have been identified, the plans of management are often expressed formally in budgets. Budgets are usually prepared under the direction of the controller, who is the manager in charge of the accounting department. ‘Typically, budgets are prepared annually, Orpanizing Planning involves deciding how to utilize available resources as plans are carried out and tackling activities necessary to achieve objectives such as staffing, subordinating, directing and motivating, Controlling Controlling involves comparing actual performance with set plans and standards and deciding what corrective actions to take should there be any deviation (variance) between actual and planned performance. In carrying out the control function, managers seek to ensure that the plan is being followed. Feedback, which signals whether operations are on track, is the key to effective control. A performance report compares budgeted to actual results. It suggests where operations are not proceeding as planned and where some parts of the organization may require additional attention. NOTE: Decision-making is an inherent function of management; all management functions would require certain amount of decision-making. Management by Objectives Management by Objectives is a procedure in which a subordinate and a supervisor agree on goals and the methods in achieving them and develop a plan in accordance with that agreement. The subordinate is then evaluated with reference to the agreed plan at the end of the period. Management by Exception Management by Exception is a technique of highlighting those which vary significantly from plans and standards in line with the management principle that executive time should be spent on items that are non-routine and are identified as top priority.Management Accounting Management Accounting refers to reports designed to meet the needs of internal users, particularly the managers. The American Association of Accountants (AAA) defined it as the application of appropriate techniques and concepts in processing the historical and projected economic data of an entity to assist management in establishing a plan for reasonable economic objectives and in the making of rational decisions with a view towards achieving these objectives. Management Accounting vs. Financial Accounting Managerial accounting is concerned with providing information to personnel within an organization so that they can plan, make decisions, evaluate performance, and control operations. There are no rules and regulations associated with this field since the information is intended solely for use within the firm. ‘ i Financial accounting, in contrast, focuses on financial statements and other financial reports. This area deals with reporting to groups outside of an organization (e.g., stockholders, lenders, government agencies) so that some assessment of profitability and overall financial health can be made. Given the large number of firms in our economy and the varying level of user sophistication, the field is heavily regulated (by the Financial Accounting Standards Board and, to a lesser degree, by the Securities and Exchange Commission). Summary of Differences: | FINANCIAL ACCOUNTING MANAGEMENT ACCOUNTING 1. Users of information Primarily for external users Exclusively for internal users_| 2. Accounting principles. Should be in accordance with | Management wants and needs Generally Accepted Accounting Principles 3. Optional/Mandatory Mandatory, particularly by the | Discretionary or optional government 4, Type of information The end-product which is}Monetary and also non- the financial statements are} monetary like units produced, primarily monetary (financial) | units sold, number of labor in nature hours, etc. 5, Emphasis on reports Reliability (precision of data) | Relevance and timeliness of data, 6. Purpose/End result To produce financial statements | To assist the management in decision-making «7. Source of data From company’s (internal) | From internal and external users information system such as economics, etc.8. Amount of detail Reports are compressed and simplified Reports are more extensive and detailed 9. Focus of information 10. Frequency of reports 11, Time orientation 12. Unifying concept Financial statements focus mainly on business as a whole Periodic (annually, quarterly) Mainly historical (past) data . Assets = Liabilities + Equity The Controller: Chief Management Accountant Controllership Focus on segments (@.g., prod- ucts, divisions, departments within the company) and busi- Ness as a whole As frequent as management need arises Future-oriented using current and past data No unifying concept or equation | Controllership is the practice of the established science of control, which is the process by which management assures itself that the company’s resources are obtained and utilized according to plans that are in line with the company’s set objectives. Controller Controller is an officer of an organization who has responsibility for the accounting aspect of management control. He generally performs two basic roles: 1. Accumulation and reporting of accounting information to all levels of management and; 2. Directing management’ attention to problems and assisting them in solving such problems. Controller vs. Treasurer | . CONTROLLER TREASURER | 1. Planning & control} 5. Government 1. Provision of 5. Credit & reporting capital collections | 2. Reporting & 6. Protection of 2. Investor relations | 6. Investments interpreting assets 3. Evaluating & 7. Economicappraisal| 3, Short-term 7. Insurance Consulting financing 4. Tax administration 4, Banking & custodyLine Function vs. Staff Function Line Function is the authority to give command or orders to subordinates. It exercises direct downward authority over line departments (¢.g., VP for operations over operations manager). Staff Function is the authority to advise but not to command others; the function of providing line and staff managers with specialized service and technical advice for support. Itis exercised laterally or upward, &° When it comes to the whole organization, a controller usually exercises staff functions since its primary function is to give advice. But when it comes to its own department, a controller exercises line functions among Its own staff. @* A Treasurer usually exercises line functions within an organization. Standards of Ethical Conduct for Management Accountants Management accountants have responsibility for ethical behavior in four broad areas, Competence, Confidentiality, Integrity and Objectivity. 1. Competence In order to be competent, management accountants must: + Maintain an appropriate level of professional competence. + Follow applicable laws, regulations, and standards. + Provide accurate, clear, concise, and timely decision support information. + Recognize and communicate professional limitations that preclude responsible judgment. 2. Confidentiality Management accountants must: + Not disclose confidential information acquited in the course of their work unless legally obligated to do so. « Ensure that his subordinates do not disclose confidential information. + Not use confidential information for unethical or illegal advantage. 3. Integrity Management accountants must: * Mitigate conflicts of interest.and advise others of potential conflicts. + Refrain from conduct that would prejudice carrying out duties ethically. + Abstain from activities that might discredit the profession. 4, Objectivity Management accountants must: + Communicate information fairly and objectively. + Disclose all relevant information that could influence a user's understanding of reports and recommendations,+ Disclose delays or deficiencies in information timeliness, processing, or internal controls. To sum up, Competence means having the capacity to function in a particular manner. Confidentiality means having the ability to maintain or keep information undisclosed. Integrity is defined as adherence to a code of moral values. Objectivity is defined as expressing or using facts without distortion by personal feelings or prejudices.