FINANCIAL ACCOUNTING & REPORTING

SOLE PROPRIETORSHIP
WEEK 01 TO WEEK 06

DEFINITION OF ACCOUNTING
Accounting is a service activity which function is to provide quantitative information,
primarily financial in nature, about economic entities that is intended to be useful in
making economic decisions. It identifies, records, and processes business activities to come
up with financial reports that are measured in monetary terms to show the financial
condition of the business.

BRANCHES OF ACCOUNTING
The technological advancement and industrial and economical development have resulted
in the evolution of various types or branches of accounting over time.
Financial accounting is concerned with the preparation of periodic financial reports by
using historical data of a business enterprise. The basic purpose of these reports is to
provide useful and timely information about an entity’s financial position and its operating
results to owners, managers, investors, creditors and government agencies etc. Financial
position refers to the resources and obligations of a business at any given point of time and
operating results means the net profit earned or net loss incurred by a business enterprise
during a particular period of time. There are certain rules known as “generally accepted
accounting principles (GAAP)” that each business enterprise must follow while preparing its
financial reports to ensure that the financial information published by it is useful, reliable
and comparable with other companies. Financial accounting is also termed as the “general
purpose accounting” because the information generated by it is published for the use of
everyone connected with the business enterprise.
Management accounting system uses historical as well as estimated data to generate
useful reports and information to be used by internal management for decision making
purpose. Unlike financial accounting, the information generated by management
accounting is not published for external parties but is used by managers to perform their
core functions such as evaluation of various products and departments in terms of
profitability, selection of the best available alternatives and making other business
decisions to achieve organizational goals. As the reports generated by management
accounting are not used by any external party, the business enterprises don’t need to take
care of GAAP.
Cost Accounting is concerned with categorizing, tracing and collecting manufacturing
costs of a business enterprise. The cost data collected so is used by management in
planning and control. A well-established cost accounting system is essential for every
business enterprise to have a proper control over costs.
Tax accounting deals with the tax related matters of a business enterprise. It includes
computation of taxable income and presentation of financial or other information to
tax authorities required by tax laws and regulations of a country. The reports and
information generated by financial accounting system satisfy the needs of external parties
to great extent. However, the rules and methods followed by a company for preparing
its financial accounting reports may slightly differ from those required by tax laws. The
work of a tax accountant is to adjust the net operating results and rearrange the
information generated by financial accounting to conform with the tax reporting
requirements of a country. Because of these functions, tax accountants need to have an
updated knowledge about tax laws and regulations. Tax accounting is also important for
managers because taxes usually have a significant impact on the expected outcomes of
proposed decisions.
Government accounting is concerned with the allocation and utilization of government
budgets. It ensures that the central or state government funds released for various
purposes are being utilized efficiently. The proper record keeping makes the audit of
completed projects possible.
Auditing generally refers to review, examination, verification, evaluation or inspection of
historical data, records or events belonging to an entity. The person who performs the work
of audit is known as auditor. In accounting and business, there are two types of auditing –
external auditing and internal auditing. External auditing refers to the independent
examination of an entity’s financial statements and other accounting records that an entity
publishes for the use of various stakeholders. The auditor gives his opinion about the
fairness of all accounting information examined by him. An important element of “fairness”
is the compliance of financial statements with the generally accepted accounting principles
(GAAP). Internal auditing is performed to determine whether or not the policies and
procedures set by management are being followed. An important purpose of internal
auditing is to evaluate whether the activities performed by the employees at various levels
are in line with the goals set by management. Internal auditing may be performed by the
existing accountants, however many companies employ special staff for this purpose.
Accounting Education refers to teaching accounting and accounting related subjects in an
organized learning environment. It is a process of facilitating the acquisition of knowledge
and skills regarding one or more of the other branches of accounting.
Accounting Research pertains to the careful analysis of economic events and other
variables to understand their impact on decisions. It deals with the creation of new
knowledge such as deciding and implementing new accounting and auditing standards,
learning how new tax laws impact clients and employers, discerning how the accounting
profession affects the capital markets, among others.

USERS OF ACCOUNTING INFORMATION

Accounting information of a business enterprise is used by many stakeholders. Different
parties use this information for different purposes depending on their needs. Therefore, the
accounting information system of a business enterprise must be designed in a way that it
should generate the reports to satisfy the information needs of every interested party.
The users of accounting information may be classified in two ways. They may be classified
as either internal users or external users and as either direct users or indirect users.
The internal users are those who have ready access to accounting information for their
decision-making needs. They include only the owners and the management. The external
users do not have ready access to accounting information and rely heavily on the prepared
financial statements of the enterprise for their decision-making needs. They include
creditors, taxing authority, suppliers, customers, employees and employee unions,
regulatory agencies, financial analysts, and the public.
The users with direct interest use financial information as a tool to protect their own
interest in the enterprise. They include the owners, managers, creditors, suppliers,
customers, employees, and taxing authority. The users with indirect interest obtain and
use accounting information to provide advice to or protect the interest of a direct user.
Users of this type include regulatory agencies which protect the interest of the investors
and the public, the labor unions which protect the interest of the employees, and financial
and legal consultants who provide advice to their clients who may be customers, lenders, or
suppliers of the enterprise.
The stakeholders use accounting information in making economic decision.
1. Owners
To protect his interest, the owner has to keep track of the enterprise’s financial condition
and financial performance. Owners invest capital to start and run business with the
primary objective to earn profit. They need accurate financial information to know what
they have earned or lost during a particular period of time. On the basis of this information
they decide their future course of actions such as expansion or contraction of business. In
small businesses (like sole proprietorship and partnership) owners themselves perform the
function of management.
2. Management
The owners of the enterprise delegate the stewardship of the enterprise’s resources to the
management. Management uses accounting information for evaluating and analyzing
organization’s financial performance and position, to take important decisions
and appropriate actions to improve the business performance in terms of profitability,
financial position and cash flows. One of the major roles of management is to set rules and
procedures to achieve organizational goals. For this purpose, management uses information
generated by financial as well as managerial accounting system of the organization.
3. Investors
In corporate form of business, the ownership is often separated from the management.
Normally investors provide capital and management runs the business. The accounting
information is used by both actual and potential investors. Actual investors use this
information to know how their funds are used by the management, and the expected
performance of business in future in terms of profitability and growth. On the basis of this
information, they decide whether to increase or decrease investment in corporation in
future. Potential investors use accounting information to decide whether or not a particular
corporation is suitable for their investment needs.
4. Lenders
Present and potential creditors assess the ability of the enterprise to pay its loans and the
interest attaching to such loans. Lenders are individuals or financial institutions that
normally lend money to businesses and earn interest income on it. They need accounting
information to assess the financial performance and position and to have a reasonable
assurance that the business to whom they are going to lend money would be able to
return the principal amount as well as pay interest thereon.
5. Suppliers
Suppliers are business individuals or organizations that normally sell merchandise or raw
materials to other businesses on credit. They use accounting information to have an idea
about the future creditworthiness of the business and to decide whether or not to continue
providing goods on credit. Suppliers of goods and services determine whether the cost of
such goods and services will be paid by the enterprise when they become due. They are
dependent upon the continuation of the enterprise as a major customer.
6. Employees
Employees do not have a hand in core management of the business. They are interested in
financial information because their present and future is tied up with the success or failure
of the business. The success and profitability of business ensures job security, better
remuneration, job promotion and retirement benefits. Employees evaluate the financial
status of the enterprise to o the latter’s ability to provide remuneration, retirement benefits,
and employment opportunities.
7. Customers
Customers have an interest information about the continuance of an enterprise, especially
when they have a long-term involvement with, or are dependent on, the enterprise as their
supplier. Accounting information provides important information to customers about
current position of a business organization and to make a judgment about its future.
Customers can be divided into three groups – manufactures or producers at various stages
of production, wholesalers and retailers and end users or final consumers. Manufacturers
or producers at every stage of processing need assurance that the organization in question
will continue providing inputs such as raw materials, parts, components and support etc.
The wholesalers and retailers must be assured of consistent supply of products. The end
users or final consumers are interested in continuous availability of products and related
accessories. Because of these reasons, the accounting information is of significant
importance for all three types of customers.
8. Government agencies
A business entity is subject to government regulations mainly for the interest of the public
investors and other parties dealing with it. The government and its agencies rely on
financial information to determine whether business entities comply with prescribed rules
and regulations. Government agencies also rely on financial information of businesses for
the purpose of imposing and collecting taxes.
9. General public
General public also uses accounting information of business organizations. For example,
accounting information is:
 a source of education for students of accounting and finance.
 a source of valuable data for those researching on organizational impacts on
individuals and economy as a whole.
 a source of information for the people looking for job opportunities.
 a source of information about the future of a particular enterprise.

TYPES OF BUSINESS ACCORDING TO ACTIVITY

Service Business

A service type of business provides intangible products (products with no physical form).
Service type firms offer professional skills, expertise, advice, and other similar products.
Examples of service businesses are: schools, repair shops, hair salons, banks, accounting
firms, and law firms.

Merchandising Business

This type of business buys products at wholesale price and sells the same at retail price.
They are known as "buy and sell" businesses. They make profit by selling the products at
prices higher than their purchase costs. A merchandising business sells a product without
changing its form. Examples are: grocery stores, convenience stores, distributors, and other
resellers.

Manufacturing Business

Unlike a merchandising business, a manufacturing business buys products with the

intention of using them as materials in making a new product. Thus, there is a
transformation of the products purchased. A manufacturing business combines raw
materials, labor, and factory overhead in its production process. The manufactured goods
will then be sold to customers.

FORMS OF BUSINESS ORGANIZATIONS

Sole Proprietorship

A type of business unit where one person is solely responsible for providing the capital and
bearing the risk of the enterprise, and for the management of the business. A sole
proprietorship is a business owned by only one person. It is easy to set-up and is the least
costly among all forms of ownership. The owner faces unlimited liability; meaning, the
creditors of the business may go after the personal assets of the owner if the business
cannot pay them. The sole proprietorship form is usually adopted by small business
entities
Characteristics of sole proprietorship form of business organization

(a) Single Ownership: The sole proprietorship form of business organization has a single
owner who himself/herself starts the business by bringing together all the resources.
(b) No Separation of Ownership and Management: The owner himself/herself manages
the business as per his/her own skill and intelligence. There is no separation of ownership
and management as is the case with company form of business organization. A sole
proprietor contributes and organizes the resources in a systematic way and controls the
activities with the objective of earning profit.
(c) Less Legal Formalities: The formation and operation of a sole proprietorship form of
business organization does not involve any legal formalities. Thus, its formation is quite
easy and simple.
(d) No Separate Entity: The business unit does not have an entity separate from the
owner. The businessman and the business enterprise are one and the same, and the
businessman is responsible for everything that happens in his business unit.
(f) Unlimited Liability: The liability of the sole proprietor is unlimited. In case of loss, if his
business assets are not enough to pay the business liabilities, his personal property can
also be utilized to pay off the liabilities of the business.
(g) One-man Control: The controlling power of the sole proprietorship business always
remains with the owner. He/she runs the business as per his/her own will.
Merits of Sole proprietorship
(a) Easy to Form and Wind Up.
(b) Quick Decision and Prompt Action.
(c) Direct Motivation.
(d) Flexibility in Operation.
(e) Maintenance of Business Secrets.
(f) Personal Touch.
Limitations of sole proprietorship
(a) Limited Resources.
(b) Lack of Continuity.
(c) Unlimited Liability.
(d) Not Suitable for Large Scale Operations.
(e) Limited Managerial Expertise.
Partnership

A partnership is a business owned by two or more persons who contribute resources into
the entity. The partners divide the profits of the business among themselves. In general
partnerships, all partners have unlimited liability. In limited partnerships, creditors cannot
go after the personal assets of the limited partners.

Characteristics of partnership form of business organization

Based on the definition of partnership as given above, the various characteristics of

partnership form of business organization can be summarized as follows:

(a) Two or More Persons: To form a partnership firm at least two persons are required. The
maximum limit on the number of persons is ten for banking business and 20 for other
businesses. If the number exceeds the above limit, the partnership becomes illegal and the
relationship among them cannot be called partnership.

(b) Contractual Relationship: Partnership is created by an agreement among the persons

who have agreed to join hands. Such persons must be competent to contract. Thus,
minors, lunatics and insolvent persons are not eligible to become the partners. However, a
minor can be admitted to the benefits of partnership firm i.e., he can have share in the
profits without any obligation for losses.

(c) Sharing Profits and Business: There must be an agreement among the partners to
share the profits and losses of the business of the partnership firm. If two or more persons
share the income of jointly owned property, it is not regarded as partnership.

(d) Existence of Lawful Business: The business of which the persons have agreed to share
the profit must be lawful. Any agreement to indulge in smuggling, black marketing etc.
cannot be called partnership business in the eyes of law.

(e) Principal Agent Relationship: There must be an agency relationship between the
partners. Every partner is the principal as well as the agent of the firm. When a partner
deals with other parties he/she acts as an agent of other partners, and at the same time
the other partners become the principal.

(f) Unlimited Liability: The partners of the firm have unlimited liability. They are jointly as
well as individually liable for the debts and obligations of the firms. If the assets of the firm
are insufficient to meet the firm’s liabilities, the personal properties of the partners can also
be utilized for this purpose. However, the liability of a minor partner is limited to the extent
of his share in the profits.

Merits of partnership form

(a) Easy to Form

(b) Availability of Larger Resources

(c) Better Decisions

(d) Flexibility

(e) Sharing of Risks

(f) Keen

(g) Benefits of Specialization

(h) Protection of Interest

(i) Secrecy

Limitations of partnership form

A partnership firm also suffers from certain limitations. These are as follows:

(a) Unlimited Liability

(b) Instability

(c) Limited Capital

(d) Non-transferability of share

(e) Possibility of Conflicts

Corporation

A corporation is a business organization that has a separate legal personality from its
owners. Ownership in a stock corporation is represented by shares of stock. The owners
(stockholders) enjoy limited liability but have limited involvement in the company's
operations. The board of directors, an elected group from the stockholders, controls the
activities of the corporation.

STEPS IN THE ACCOUNTING CYCLE

Accounting Cycle, also known as “accounting process” or “Bookkeeping Process” is the
start-to-end process to be followed sequentially, or at times, simultaneously for recording
the financial and accounting events occurring in any organization.
In earlier times, these steps were followed manually and sequentially by an accountant. But
these days, many softwares, like Tally, SAP, ERP, etc complete all the steps involved in
accounting process simultaneously, and the user is just required to initiate the process by
providing the relevant financial data.
1. Analyzing:
The first step of the accounting cycle is to analyze the accounting transaction and
determine the nature of the accounts involved so that proper recording can be done.
2. Journalize:
After determining the accounts involved, the next step is to journalize the transaction in a
Journal Book, which is also called the Book of Original Entry because this is the first
record where transactions are entered. Transactions in a Journal are entered as and when
they occur in a chronological order. A Journal is prepared on the concept of Double Entry,
where every transaction affects at least two accounts, i.e. debit to one account and credit to
another.
3. Posting:
After Journalizing, the accounting transactions are posted to Ledger accounts in order to
classify and group transactions relating to a single account at one place.
4. Summarizing:
The accounting cycle requires summarizing of the entries pertaining to a particular period
in a trial balance. A trial balance is essentially a list of all accounts (debit as well as credit)
and provides an overview of the various types of financial transactions entered into by any
organization during a period.
5. Adjusting:
After preparation of trial balance, the next step is to pass journal entries pertaining to
certain adjustments, like, recording of closing stock, adjusting prepaid/outstanding
expenses, recording advance/accrued income, etc. These journal entries are known as
adjusting entries.
6. Correcting:
After the adjusting entries are passed and posted to respective ledger accounts, the trial
balance has to be corrected and adjusted to show the impact of the adjusting entries. For
this purpose, an amended trial balance is prepared. This amended trial balance is known
as adjusted trial balance.
7. Organizing:
The next step in the accounting cycle is to organize the various accounts by preparing the
financial statements, namely, balance sheet, income statement, changes in owner’s equity,
and cash flows. The income statement shows all the expenses incurred and incomes earned
by the organization during a financial period. The balance sheet is a depiction of the
financial position of the business and displays the various assets owned and liabilities
owed (to owners and outsiders) by and organization.
8. Closing:
After preparation of the profit and loss account/income statement and balance sheet, the
accounts have to be closed to prepare for the next accounting period. The temporary
accounts, i.e. nominal accounts (income and expenses accounts) are closed by transferring
their balances to the profit & loss account by means of a single consolidated journal entry
and then the profit & loss account is closed by transferring the profit or loss to the capital
account.
9. Finalizing:
The last step is to prepare the final trial balance showing the effect of all the transactions of
the year and having closing balances of the accounts for the year. This closing trial
balance serves as the base/opening trial balance for the next year’s accounting cycle.

BASIC ACCOUNTING CONCEPTS

Accrual concept of accounting
The accrual accounting is a system used by companies to record their financial transaction
at the point when they occur regardless of whether a cash transfer has been made. It is
unlike cash accounting in which transaction is deemed as valid for recording when cash is
actually received or paid.

Going concern concept

The going concern concept of accounting implies that the business entity will continue its
operations in the future and will not liquidate or be forced to discontinue operations due to
any reason. A company is a going concern if no evidence is available to believe that it will or
will have to cease its operations in foreseeable future.

Matching principle of accounting

Matching principle is an important concept of accrual accounting which states that the
revenues and related expenses must be matched in the same period to which they relate.
Additionally, the expenses must relate to the period in which they have been incurred and
not to the period in which the payment for them is made. For example, a company
consumes electricity for the whole month of January, but pays its electricity bill in
February. So if the company has been operating under “cash based accounting”, they may
have recorded the expense in the month of February, as it has actually paid cash in
February. But under “accruals accounting” the entity is bound to record the electricity
expense for the month of January and not February, because the expense has originally
been incurred in January.

Revenues recognition: For a company, revenues must be recognized when the entity is sure
that it has earned those revenues by fulfilling their part of agreement and that the other
party will also fulfill its duty in terms of payment.
Expenses recognition: Expenses must be recognized when they are incurred and the
revenue connected to them is recognized, irrespective of the outflow of cash or its
equivalent.

Business entity concept

The business entity concept (also known as separate entity and economic entity concept)
states that the transactions related to a business must be recorded separately from those of
its owners and any other business. In other words, while recording transactions in a
business, we take into account only those events that affect that particular business; the
events that affect anyone else other than the business entity are not relevant and are
therefore not included in the accounting records of the business.

Monetary unit assumption

Monetary unit assumption (also known as money measurement concept) states that only
those events and transactions are recorded in books of accounts of the business which can
be measured and expressed in monetary terms. Information which cannot be expressed in
terms of money is useless for financial accounting purpose and is therefore not recorded.

Time period assumption

The time period assumption (also known as periodicity assumption and accounting time
period concept) states that the life of a business can be divided into equal time periods.
These time periods are known as accounting periods for which companies prepare their
financial statements to be used by various internal and external parties. The length of
accounting period to be used for the preparation of financial statements depends on the
nature and requirement of each business as well as the need of the users of financial
statements. Normally, an accounting period consists of a quarter, six months or a year.

Revenue recognition principle

Revenue recognition principle of accounting (also known as realization concept) guides us
when to recognize revenue in accounting records. According to this concept, the revenue is
not recognized until it is earned and it is realized or at least realizable. The revenue is
referred to have been earned when the entity sells goods or renders services and transfers
the associated rewards and benefits to the buyer. At this point, the entity is generally
entitled to the revenue because the value of goods and services provided can be objectively
measured and the earning process is considered to have been completed. This condition
focuses on the entity’s entitlement to the revenue. According to revenue recognition
principle, the revenue is recognized when the entity is entitled to receive it, not at the time
when it is actually received. The revenue is referred to have been realized when goods are
sold or services are provided in exchange of cash or claims to cash (i.e., accounts
receivable). The revenue is referred to be realizable when goods are sold or services are
provided in exchange of an asset other than cash and such asset is readily convertible into
cash or is exchangeable with other useful assets within reasonable time period and without
incurring any additional cost. Revenue recognition principle requires that the revenue must
be realized or realizable in order to recognize it in the accounting records.
Materiality concept of accounting
The materiality concept of accounting states that all material items must be properly
reported in the financial statements. An item is considered material if its inclusion or
omission significantly impacts the decision of the users of financial statements. The items
that have very little or no impact on a user’s decision are termed as immaterial or
insignificant items Such items may be handled in most convenient and easiest manner. In
short, we can say that if an item does not make a difference, it need not be disclosed. The
materiality concept also permits accountants to ignore another accounting principle or
concept if such action does not have an important effect on financial statements of the
entity. Materiality of an amount is a matter of professional judgment. Several factors are
considered to decide whether a particular item is material or immaterial, such as size of the
organization, its cumulative effect, and nature of the item.

Historical cost concept

The historical cost concept (also known as cost principle of accounting) states that the
assets and liabilities of a business should be presented in accounting records at their
historical cost. Historical cost is the amount that is originally paid to acquire the asset and
may be different from the current market value of the asset. An important advantage of
historical cost concept is that the records kept on the basis of it are considered consistent,
comparable, verifiable and reliable.

Full disclosure principle of accounting

According to this principle, the management of an entity is required to disclose all the
relevant and appropriate information (both financial and non-financial) in their financial
statements that could impact the decision-making behavior of the users of those
statements. Such information is made available to the owners and other users either on the
face of financial statements or in the notes to the financial statements.

Consistency principle of accounting

The consistency principle of accounting states that a company should use the same
accounting policies and methods for recording similar events or transactions from one
financial period to another. It is necessary that a company consistently apply its accounting
methods and policies from one financial year to another. A company can change its
accounting methods and policies only and only if there are one or more reasonable grounds
to do so and the change reflects a more accurate picture of financial performance and
position of the business in company’s financial statements.

Comparability concept of accounting

The comparability concept of accounting states that the users of financial reports of a
business must be able to compare these reports with previous years’ reports as well as with
reports of other entities dealing in the same industry. The comparability concept suggests
that the financial statements must be prepared under same accounting principles and
methods each year. The comparability is achieved when the entity follows same accounting
rules which are followed by every business in the industry and/or as directed by law of
jurisdictions.
Understandability concept of accounting
The understandability concept of accounting states that the information provided in
the financial statements must be easily understandable by the end users of those financial
statements.

Substance over form concept

The concept substance over form means that the transactions recorded in the financial
statements must reflect their economic substance rather than their legal form. The concept
signifies that transactions must be seen according to their economic or financial reality
instead of their legal formation to foster a more objective picture of the transactions and
events.

Prudence concept of accounting

Prudence concept of accounting states that an entity must not overestimate its revenues,
assets, and profits. Besides these, it must not underestimate its liabilities, losses, and
expenses. Prudence concept is a very fundamental concept of accounting that increases
the trustworthiness of the figures that are reported in the financial statements of a
business. The concept advises that the final accounts of a company must always show
caution while reporting any figures specifically impacting the income and expenses.

QUALITATIVE CHARACTERISTICS OF FINANCIAL STATEMENTS

The elements of financial statements namely the statement of financial position, income
statement, statement of changes in equity, statement of cash flows mainly show the
relevant financial data to a business. The disclosure notes mostly include the non-
financial data that assists the users of the statements to understand the numbers depicted
in financial data. Following are the main qualitative characteristics of financial statements:

Understandability
It is important that the financial statements are prepared in such a way that is easy to
understand and interpret for the stakeholders. The information provided in these
statements must be clear and legible.

Relevance
The information provided in the financial statements must be relevant to the “information
needs” of its users which could affect their economic decisions.

Reliability
The information provided in the financial statements must be reliable and true. The
information extracted to prepare these financial statements must be from reliable and
trustworthy sources. The financial statements must depict the true and fair picture of the
status of the company affairs. This means that the information provided must not have any
significant errors or material misstatements. The transactions shown must be based on the
concepts of prudence and must represent the true nature of company’s transactions and
operations. The areas that are judgmental and subjective in nature must be presented with
due care and keen competence.

Comparability
The financial statements must be prepared in such a way that they are comparable with
prior year financial statements. This characteristic of financial statements is very important
to maintain, as it makes sure that the performance of the company could be monitored and
compared. This characteristic is maintained by adopting accounting policies and standards
that are applied are consistent from period to period and between different jurisdictions.
This enables the users of the financial statements to identify and plot trends and patterns
in the data provided, which makes their decision making easier.

Timeliness
All the information in the financial statements must be provided within a relevant span of
time. The disclosures must not be excessively late or delayed so that while making their
economic decisions the users of these statements possess all the relevant and up-to-date
knowledge. Although this characteristic may take more resources but still it is a vital
characteristic as delayed information makes any corrective reactions irrelevant.

THE FIVE MAJOR ACCOUNTS

In accounting, the accounts are classified using one of two approaches – modern approach
or traditional approach. We shall describe modern approach first because this approach
of classification of accounts is used in almost every advanced country. The use of
traditional approach is very limited.
Modern approach
According to modern approach, the accounts are classified as asset accounts, liability
accounts, capital or owner’s equity accounts, withdrawal accounts, revenue/income
accounts and expense accounts.
1. Asset accounts:
Assets are things or items of value owned by a business and are usually divided into
tangible or intangible. Tangible assets are physical items such as building, machinery,
inventories, receivables, cash, prepaid expenses and advance payments to other parties.
Intangible assets normally include non-physical items and rights. Examples of intangible
assets include goodwill, trademarks, copyrights, patent rights and brand recognition etc.
A separate account for each tangible and intangible asset is maintained by the business to
record any increase or decrease in that account.
2. Liability accounts:
Liabilities are obligations or debts payable to outsiders or creditors. The title of a liability
account usually ends with the word “payable”. Examples include accounts payable, bills
payable, wages payable, interest payable, rent payable and loan payable etc. Besides these,
any revenue received in advance is also a liability of the business and is known
as unearned revenue. For example, a marketing firm may receive marketing fee from its
client for the forthcoming quarter in advance. Such unearned revenue would be recorded as
a liability as long as the related marketing services against it are not provided to the client
who has made the advance payment.
3. Capital or owner’s equity accounts:
Capital is the owner’s claim against the assets of the business and is equal to total assets
less all liabilities to external parties. The balance in capital account increases with the
introduction of new capital and profits earned by the business and decreases as a result of
withdrawals and losses sustained by the business.
In sole proprietorship, a single capital account titled as owner’s capital account or simply
capital account is used. In partnership or firm, each partner has a separate capital account
like John’s capital account, Peter’s capital account etc. In corporate form of business there
are many owners known as stockholders or shareholders and the title capital stock account
is used to record any change in the capital.
Withdrawals are cash or assets taken by a business owner for his personal use. In sole
proprietorship and partnership, an account titled as drawings account is used to account
for all withdrawals. In corporate form of business withdrawals are more systematic and
usually termed as distributions to stockholders. The account used for recording such
distributions is known as dividend account.
4. Revenue or income accounts:
Revenue is the inflow of cash as a result of primary activities such as provision of services
or sale of goods. The term income usually refers to the net profit of the business derived by
deducting all expenses from revenue generated during a particular period of time. However,
in accounting and finance, the term is also used to denote all inflows of cash resulted by
those activities that are not primary revenue generating activities of the business. For
example, a merchandising company may have some investment in an oil company. Any
dividend received from oil company would be termed as dividend income rather than
dividend revenue. Other examples of income include interest income, rent income and
commission income etc. The businesses usually maintain separate accounts for revenues
and all incomes earned by them.
5. Expense accounts:
Any resource expended or service consumed to generate revenue is known as expense.
Examples of expenses include salaries expense, rent expense, wages expense, supplies
expense, electricity expense, telephone expense, depreciation expense and miscellaneous
expense.
Traditional approach
According to traditional approach, the accounts are classified into four types – personal
accounts, real accounts, nominal accounts, and valuation accounts. A brief explanation of
each is given below:
1. Personal accounts:
The accounts related to real persons and organizations are classified as personal accounts.
Examples of personal accounts include John’s account, Peter’s account, Procter and
Gamble’s account, Vibrant Marketing Agency’s account and City bank’s account etc. The
business keeps a separate account for each individual and organization for the purpose of
ascertaining the balance due from or due to them.
2. Real accounts:
Real accounts are accounts related to assets or properties (both tangible and intangible)
owned by a business enterprise. A separate account for each asset is maintained to account
for increases and decreases in that asset. Examples of real accounts include cash account,
inventory account, investment account, plant account, building account, goodwill account,
patent account, copyright account etc.
3. Nominal accounts:
The accounts related to incomes, gains, expenses and losses are classified as nominal
accounts. These accounts normally serve the purpose of accumulating data needed for
preparing income statement or profit and loss account of the business for a particular
period. Examples of nominal accounts include sales account, purchases account, wages
account, salaries account, interest account, rent account, gain on sale of fixed assets
account and loss on sale of fixed assets account etc.
4. Valuation account:
Valuation account (also known as contra account) is an account used to report the carrying
value of an asset or liability in the balance sheet. A popular example of valuation account is
the accumulated depreciation account. Companies maintaining fixed assets in the books of
accounts at their original cost also maintain an accumulated depreciation account for each
fixed asset. In balance sheet, the balance in the accumulated depreciation account is
deducted from the original cost of the asset to report it at its book value or carrying value.
Another example of valuation account is allowance for doubtful accounts. In balance sheet,
the balance in allowance for doubtful accounts is deducted from the total receivables to
report them at their net realizable value or carrying value.

CHART OF ACCOUNTS
Chart of accounts is simply a list of account names that a company uses in its general
ledger for recording various business transactions. It provides guidance to bookkeepers,
accountants or other relevant persons in using specific account names while entering
transactions in journal and posting them to ledger.
Structure or template
There is no common structure or template of chart of accounts available for the use of all
types of businesses. Each company prepares its own chart of accounts depending on its
individual requirements. The structure of a chart of accounts is normally as complex as the
business structure of the company. For example, the type and number of accounts
needed by a large corporation would significantly differ from those needed by a small
retailer. Similarly many accounts that are essential in manufacturing businesses are not
used by merchandising companies.
Example
Following is an example chart of accounts of a merchandising company:

ACCOUNTING EQUATION
Accounting equation is the foundation of modern double entry system of accounting as it
describes that the total value of assets of a business is always equal to its liabilities plus
owner’s equity. The general form of this equation is

Assets = Liabilities + Owner’s Equity

Assets – economic resources owned by the business, that are expected to benefit the
business over a period of time.
Liabilities – simply defined as debts, or what the business owes
Equity – the net assets claimable by the owners, the residual rights or interest of the
owner(s), depending on the form of business, may either be called as partners’ equity or
shareholders’ equity

Notice that the equation’s left side shows the resources owned by the business and the
equation’s right side shows the sources of funds used to acquire the resources. The total
amounts of these two sides are always equal because they represent two different views of
the same thing.

If the amounts of any two of the three elements are known, one can use the equation to
find the third one. For example, if a business has total assets amounting to P100,000 and
total liabilities amounting to P60,000, the owners equity must be equal to P40,000 as
computed below:

Assets – Liabilities = Owner’s Equity

P100,000 – P60,000 = P40,000

To show the increase and decrease in the equity due to economic events, the accounting
equation is further extended

Assets = Liabilities + Owner’s Equity – Drawing + Revenues – Expenses

Drawing – withdrawal of business assets for personal use

Revenues – earning or income of the business when goods are sold or services are rendered.
Expenses – amount or value of goods and services paid for or given up by a business entity
in order to earn.

Example: Using the concept of accounting equation, compute missing figures from the
following:
1. Assets = P50,000, Liabilities = P20,000, Owner’s equity = ?
2. Assets = ?, Liabilities = P10,000, Owner’s equity = P15,000
3. Assets = P60,000, Liabilities = ?, Owner’s equity = P40,000
4. Assets = ?, Liabilities + Owner’s equity = P150,000

Solution
1. Owner’s equity = Assets – Liabilities
= P50,000 – P20,000
= P30,000
2. Assets = Liabilities + Owner’s equity
= P10,000 + P15,000
= P25,000
3. Liabilities = Assets – Owner’s equity
= P60,000 – P40,000
= P20,000
 4. If liabilities plus owner’s equity is equal to P150,000, then, the assets must also be
equal to P150,000.

BUSINESS TRANSACTIONS AND THEIR ANALYSIS

In accounting, the business transaction (also known as financial transaction) is an event or
economic activity that must be measurable in terms of money and that essentially impacts
the financial position of the business. A business transaction is characterized by (1) an
exchange of values (2) in terms of money (3) between two parties. It should always be
supported by one or more source documents before it can be recorded in the company’s
books of accounts. A source document is any document that provides the needed
information, and serves as proof of a valid transaction.
A business starts with financing activities. The owner finances the business with a start-up
capital in cash and other resources. If the owner’s contribution is not sufficient, additional
financing can be extended by banks and other financial institutions. Financing activities
also include withdrawals (capital withdrawn) made by the owner, as well as loans repaid to
lenders.
As business needs resources other than cash to make it possible to operate, investing
activities involve the acquisition of properties such as land, furniture, machinery, and
equipment. Eventually these properties are disposed or retired on its maturity date.
Operating activities are the day to day activities related to earning of income when goods or
services are sold, and the incurring of expenses when wages, rent, utilities, transportation,
and the like are paid.

BUSINESS TRANSACTION EFFECTS TO THE ACCOUNTING

STRUCTURE
Below is a summary on how a business transaction affects the accounting structure. One
may use this later on as guide in the recording process, or journalizing.
Financing

Start-up; Beginning; Inception Asset increases; Equity increases

Additional investment Asset increases; Equity increases

Withdrawal of investment Asset decreases; Equity decreases

Loan/Debt/Borrowing Asset increases; Liability increases

Payment of loan Asset decreases; Liability decreases

Investing
From one form of asset to another form of Asset increases; Asset decreases
asset

Operating

Earning Asset increases; Revenue increases

Spending Asset decreases; Expense increases

or

Liability increases; Expense increases

Illustration:
Johan invested P100,000 to start a variety store Asset increases; Equity increases

Purchased machinery on account P50,000 Asset increases; Liability increases

Paid bank loan of P100,000 Asset decreases; Liability decreases

Sales on account P250,000 Asset increases; Revenue increases

Paid the weekly wages of workers P35,000 Asset decreases; Expense increases

DOUBLE ENTRY SYSTEM OF ACCOUNTING

The double entry system of accounting or bookkeeping is based on the fact that
each business or economic transaction brings two financial changes or affects two accounts
in the business, and there is no exception to it. These changes are recorded as debits or
credits in two or more different accounts. In double entry system, every debit entry must
have a corresponding credit entry, and the other way around. It creates an equilibrium
within the records which helps in detecting errors, omissions and frauds.

RULES OF DEBIT AND CREDIT

For an asset account, whose normal balance is Debit, an increase is recorded on the debit
side and a decrease is recorded on the credit side. Another account whose normal balance
is Debit is an expense account. Hence, similar to assets, an increase is recorded on the
debit side and a decrease is recorded on the credit side of all expense accounts.
Meanwhile, for a liability account, whose normal balance is Credit, an increase is recorded
on the credit side and a decrease is recorded on the debit side. The same holds true for
revenue accounts and capital or equity accounts.
The normal balance of contra accounts is always the opposite of its relevant account. In
other words, the normal balance of a contra account can be a debit or a credit.

THE BOOKS OF ACCOUNTS

The general journal, also known as book of original entry, is the book where accounting
transactions are recorded in chronological order. This act of recording is known as
journalizing.
Entries from the general journal are periodically transferred to the respective ledger
accounts. This act of transferring is known as posting. The book in which ledger accounts
are maintained is known as the general ledger or book of final entry.
Special journals are journals that an entity maintains to record business transactions that
are frequent or repetitive in nature. Typical special journals maintained by an entity are
sales journal, purchase journal, cash receipts journal, and cash disbursements journal.

PROCESS OF MAKING A JOURNAL ENTRY

In preparing a journal entry, the initial step is to identify the accounts involved, how these
accounts are affected by the business transaction, and then apply the rules of debit and
credit based on the type of each account. A journal entry contains the following:
1. Date
2. Account title and the amount to be debited
3. Account title and the amount to be credited
4. Explanation
5. Folio or Reference
A journal entry with one debit and one credit is called a simple journal entry, while a
journal entry with more than one debit and credit is called a compound journal entry.

Using the effects of business transactions to the accounting structure as bases:

1. If an asset increases, the asset account should be on the debit side or part of the journal
entry; while if an asset decreases, the asset account should be on the credit side or part of
the journal entry.

2. If a liability decreases, the liability account should be on the debit side or part of the
journal entry; while if a liability increases, the liability account should be on the credit side
or part of the journal entry.

3. If the equity decreases, the equity account should be on the debit side or part of the
journal entry; while if the equity increases, the equity account should be on the credit side
or part of the journal entry.

4. If revenue decreases, the revenue account should be on the debit side or part of the
journal entry; while if revenue increases, the revenue account should be on the credit side
or part of the journal entry.
5. If expense increases, the expense account should be on the debit side or part of the
journal entry; while if expense decreases, the expense account should be on the credit side
or part of the journal entry.

UNADJUSTED TRIAL BALANCE

Once the business transactions have been analyzed, translated into journal entries, and
posted to the ledger, the next step will be to determine the balance of each account.
Extracting the balance for each account leads to the preparation of what is known as
unadjusted trial balance.

The unadjusted trial balance is a list of ledger accounts and their balances that is prepared
after posting to the general ledger but before the formulation of adjusting entries. The main
purpose of preparing an unadjusted trial balance is to check the mathematical equality of
debits and credits. The total of the debit column of the unadjusted trial balance should
always be equal to the total of the credit column. If they are not in agreement, it may mean
any, if not all, of the following procedures were done incorrectly and inaccurately:

1. Balance extraction or computation of each ledger account

2. Posting of the journal entries to the ledger accounts
3. Formulation of journal entries
4. Analysis of the business transaction’s effect on the major accounts

The unadjusted trial balance consists of columns for the account titles, amount of debit
balance, and amount of credit balance. The accounts are listed in the following order:

1. Assets;
2. Liabilities;
3. Owner’s Equity;
4. Revenues; and
5. Expenses.

A simple format of unadjusted trial balance is given below:

 Company Name
Unadjusted Trial Balance
Date

Account Title Debit Credit

Cash 35,000
Accounts Receivable 225,000
Machinery 75,000
Patent 30,000
Accounts Payable Trade 52,000
Notes Payable 150,000
Drew, Capital 60,000
Drew, Drawing 5,000
Professional Fees Revenue 168,000
Salaries & Wages 38,000
Rent Expense 15,000
Utilities Expense 7,000
------------ ------------
Totals 430,000 430,000
========= =========

ADJUSTING ENTRIES
The preparation of adjusting entries comes after the preparation of unadjusted trial
balance. Adjusting entries are journal entries that are made at the end of an accounting
period to adjust or update the accounts to accurately reflect the revenues and expenses of
the current period.

The following are the usual accounts adjusted prior to closing the books of accounts

1. Deferred Income
2. Prepaid Expenses
3. Accrued Income
4. Accrued Expenses
5. Bad Debts or Doubtful Accounts
6. Depreciation
Deferred Income (Revenue) represents income already collected but not yet earned, which
is considered as a Liability. At the end of the year, the earned portion should be taken out
from the Liability and recognized as Income.

Liability Approach

Original Entry: Cash XXX

Deferred Income XXX

To record collection in advance

Adjusting Entry: Deferred Income XXX

Appropriate Income Account XXX

To recognize the earned portion

Income (or Revenue) Approach

Original Entry: Cash XXX

Appropriate Income Account XXX

To record collection in advance

Adjusting Entry: Appropriate Income Account XXX

Deferred Income XXX

To recognize the earned portion

Prepaid Expenses (or Prepayments) represent advance payment for service that has yet
to be rendered. At the end of the year, the expired portion of the prepayment is transferred
to an Expense account.

Asset Approach

Original Entry: Prepaid Expense XXX

Cash XXX

To record the prepayment

Adjusting Entry: Appropriate Expense Account XXX

Prepaid Expense XXX

 To record the expired portion of the prepayment

Expense Approach

Original Entry: Appropriate Expense Account XXX

Cash XXX

To record the prepayment

Adjusting Entry: Prepaid Expense XXX

Appropriate Expense Account XXX

To establish the prepayment’s unexpired portion

Accrued Income represents income already earned but not yet collected or received.

Adjusting Entry: Appropriate Receivable Account XXX

Appropriate Income Account XXX

Accrued Expenses represent expenses already incurred but not yet paid.

Adjusting Entry: Appropriate Expense Account XXX

Accrued Expenses Payable XXX

Bad Debts or Doubtful Accounts is provided since some customers may not be able to
pay. This may either be a Direct Write Off Method or Allowance Method. Direct Write Off is
applied only when it is certain that a company will not be able to collect from the customer.
The Allowance Method provides for accounts that may not be collected from the customer
in the future. Following are the methods in estimating Bad Debts or Doubtful Accounts:

1. Providing a certain percentage of Sales as Bad Debts

2. Increasing the allowance by a certain percentage of Accounts Receivable
3. Increasing the allowance to a certain percentage of Accounts Receivable
4. Aging the Accounts Receivable
Adjusting Entry 1: Bad Debt Expense XXX

Accounts Receivable XXX

Adjustment using Direct Write Off method

Adjusting Entry 2: Provision for Doubtful Accounts XXX

 Allowance for Doubtful Accounts XXX

Adjustment using Allowance method

Depreciation is provided when the utility value of an Asset is spread over its estimated
useful life. This is computed by deducting the Scrap Value of the Asset from its Cost, and
dividing the difference by its estimated useful life in number of years.

Adjusting Entry: Depreciation Expense XXX

Accumulated Depreciation XXX

COMPLETING THE ACCOUNTING CYCLE

ADJUSTED TRIAL BALANCE
The adjusted trial balance is prepared after all the adjusting entries are taken into account
and posted. This shall be the basis in the preparation of the financial statements. Although
the adjusted trial balance is not a part of financial statements, it is a statement or source
document, and is helpful in situations where financial statements are prepared manually.
Its format is basically the same as that of unadjusted trial balance.

PREPARATION OF FINANCIAL STATEMENTS

After the preparation of the adjusted trial balance, its amounts can be directly used to
prepare the financial statements. The following are the components of a complete set of
financial statements:

1. Statement of Financial Position (Balance Sheet)

2. Statement of Financial Performance (Income Statement)
3. Statement of Changes in Equity
4. Statement of Cash Flows
Notes or Disclosures to the Financial Statements is also a vital component of the complete
set of financial statements.

Statement of financial position, also known as the Balance Sheet, is a financial statement
that shows the assets, liabilities and owner’s equity of a business at a particular date. Even
though this can be prepared at any time, it is mostly prepared at the end of the accounting
period.

There are two (2) formats available in presenting the statement of financial position. The
first one is the account format, where the balance sheet is divided into left and right sides
just like in a T-account, assets on the left side while liabilities and owner’s equity is on the
right side. Then, there is the report format, where the balance sheet elements are presented
vertically, the assets section is presented at the top and liabilities and owner’s equity
sections are presented below the assets section.

Statement of financial performance, also known as Income Statement, is the financial

statement that summarizes the operating results of the business, and shows how the
business operated or produced wealth at a point in time. If the total revenue is greater
than total expenses, the result is called Profit. However, if the total revenue is less than
the total expenses, the result is called Loss. In some cases, the total revenue is equal to the
total expenses. This situation is known as Breakeven.

Statement of changes in equity explains why the owner’s share changed for a period of time.
The result found in the statement of financial performance or income statement is
considered in its preparation. A profit increases the owner’s equity, while a loss decreases
the owner’s equity. Other transactions such as owner’s additional investment or
withdrawal are also considered in the preparation of the statement of changes in equity.
Statement of cash flows shows why the amount of cash changed over a period of time. It
shows the company’s sources (cash receipts) and application of cash (cash disbursements).

CLOSING JOURNAL ENTRIES

Closing journal entries may be defined as journal entries prepared at the end of the
accounting period to transfer the balances of various temporary ledger accounts (nominal
accounts) to the permanent ledger accounts (real accounts).

Closing the revenue accounts is done by debiting various revenue accounts and crediting
Income Summary account. This step closes all revenue accounts.

Closing the expense accounts is done by debiting Income Summary account and crediting
various expense accounts. This step closes all expense accounts.

Whatever balance the Income Summary account may have after closing the revenues and
expense accounts, such amount is closed to the owner’s equity account. Any owner’s
withdrawal during the accounting period is also closed to the owner’s equity account.

POST-CLOSING TRIAL BALANCE

The post-closing trial balance, also known as after-closing trial balance, is prepared after
preparing the closing entries and posting its effects to the relevant ledger accounts. The
post-closing trial balance consists only of permanent ledger or real accounts. The purpose
of preparing a post-closing trial balance is to assure that accounts are in balance and ready
for recording transactions in the next accounting period.

REVERSING JOURNAL ENTRIES

Reversing entries are entries usually made in the first day of the next accounting period to
reverse certain adjusting entries in the immediately preceding period.
MERCHANDISING BUSINESS
Merchandising Business is one that buys products and sells the same without changing its
form at a price higher than the purchase costs. Examples are grocery stores, distributors,
and other resellers. The goods or merchandise purchased for resale to customers is
referred to as Merchandise Inventory. Merchandising companies that purchase and sell
directly to consumers are known as retailers, while those that sell to retailers are known as
wholesalers.

INVENTORY SYSTEM
Perpetual Method is the inventory system where complete movement of the goods or
merchandise is recorded. There is a continuous recording and control of the goods or
merchandise from the time it is purchased to the time it is sold.

Periodic Method is the inventory system where the goods or merchandise bought is
recorded as Purchases representing goods available for sale. When the goods are sold, only
the sales revenue representing the amount obtained from the customer is recorded.

The company can only elect or choose one inventory system for its business.

SALES
The primary activity which serves as source of revenue for a merchandising company is its
selling activity. This is embodied in the account title Sales or Sales Revenue.

To record sales using the periodic inventory system

Cash or Accounts Receivable XXX

Sales XXX
To record sales using the perpetual inventory system
Cash or Accounts Receivable XXX

Sales XXX
Cost of Goods Sold XXX

Merchandise Inventory XXX

NET SALES
Net Sales is computed by deducting Sales Discount and Sales Returns & Allowances from
Sales. These two accounts are contra-account of Sales.

Sales Discount is either a Trade Discount or Cash Discount. Accounting for these two types
of sales discount is shown below:

Trade Discount is a percentage reduction from a published or list price granted at the point
of sale to retailers and wholesalers. This kind of discount is granted for buying large
quantities or for regularly patronizing the business. The company need not record this
discount in its books of accounts.

Journal Entry at the time of sale

Cash or Accounts Receivable XXX

Sales XXX
Note: Sales is recorded net of trade discount

Cash Discount is a percentage reduction from the published or list price when goods or
merchandise are sold on account. The company records this kind discount in its books of
accounts as Sales Discount. Sales Discount is a contra revenue account to Sales. The
usual terms is expressed as 2/10 n/30 and the like.

Journal Entry at the time of sale

Accounts Receivable XXX

Sales XXX
Note: Sales is recorded at gross selling price

Journal Entry if payment from the customer is received on or before the 10th day
Cash XXX

Sales Discount XXX

Accounts Receivable XXX

Journal Entry if payment from the customer is received beyond the 10th day
Cash XXX

Accounts Receivable XXX

Note: Sales is recorded at gross selling price, and discount is neither recognized nor
recorded.
Sales Returns & Allowances is another contra revenue account that is recognized and
recorded when a customer returns a defective or broken goods or merchandise. It is
evidenced or supported by a document called Credit Memorandum issued by the seller.
Accounting for sales returns & allowances is shown below:

Journal Entry at the time of sale

Cash or Accounts Receivable XXX

Sales XXX

Journal Entry at the time the goods or merchandise is returned

Sales Returns & Allowances XXX

Cash or Accounts Receivable XXX

PURCHASES
Under the perpetual inventory system, purchases of merchandise for sale are recorded in
the Inventory account. For a cash purchase, Cash is credited; for a credit purchase,
Accounts Payable is credited. Under the periodic inventory system, purchases of
merchandise for sale are recorded in the Purchases account.

Journal Entry to record purchase of merchandise

Purchases XXX

Cash or Accounts Payable XXX

Purchase Returns and Allowances is recognized and recorded by the buyer when defective
goods or merchandise are returned to the seller. This is a contra account, and is deducted
from Purchases.

Journal Entry to record return of merchandise

Cash or Accounts Payable XXX

Purchase Returns & Allowances XXX

Purchase Discount is recognized and recorded by the buyer when cash discount is granted
by the seller. Another contra account, and is deducted from Purchases.

Journal Entry to record return of merchandise

Purchases XXX

Cash or Accounts Payable XXX

Purchase Discount XXX

Transportation In, also known as Freight In, pertains to the cost of transporting the goods.
This account is added to Purchases.

FOB Shipping Point arrangement transfers the title of ownership of the goods or
merchandise to the buyer when the seller turns over the goods or merchandise to a
common carrier for delivery to the buyer.

Entry (Seller): Accounts Receivable XXX

Sales XXX

Entry (Buyer): Purchases XXX

Freight In XXX

Accounts Payable XXX

FOB Destination arrangement is where title of the ownership of the goods or merchandise
is retained by the seller until the goods or merchandise reaches the buyer. With this kind
of arrangement, the seller, who is liable for the cost of freight, should recognize and record
the account Transportation Out or Freight Out, which is considered a selling expense.

Entry (Seller): Accounts Receivable XXX

Sales XXX

Entry (Seller): Freight Out XXX

Cash XXX

Entry (Buyer): Purchases XXX

Accounts Payable XXX

COST OF GOODS SOLD

The expenses of a merchandising business are divided into two categories:

(1) Cost of Goods Sold; and

(2) Operating Expenses.

The Cost of Goods Sold (at times called Cost of Sales) is the cost of the products that a
retailer, distributor, or manufacturer has sold. The Cost of Goods Sold is reported in
the Statement of Financial Performance or Income Statement, and should be viewed as
an expense being matched with the revenues of the accounting period. In essence, the Cost
of Goods Sold is an expense being matched with the revenues from the goods sold, thereby
achieving the Matching Principle of accounting.

Shown below is the computation for Cost of Goods Sold

Merchandise Inventory, beginning Pxxx

Add: Net Purchases xxx
--------
Available for Sale Pxxx
Less: Merchandise Inventory, end xxx
--------
Cost of Goods Sold Pxxx
======

Operating expenses are expenses incurred by a merchandising business in the process of

recognizing its sales revenue. When Cost of Goods Sold is subtracted from Sales, the result
is called the Gross Profit. After gross profit is calculated, operating expenses are deducted to
determine Net Income (or Loss).

For a more extensive read on the above-mentioned topics, the following references
are recommended:
1. Manuel, Zenaida Vera-Cruz, 21st Century Accounting Process Basic Concepts
and Procedures, 24th edition, 2018;
2. Millan, Zeus Vernon B., Financial Accounting & Reporting – Fundamentals, 2nd
edition; 2019

Disclaimer: This module is for class discussion purposes only, and not for publication. The
illustration problems were adapted from the sources & references.
 SOURCES & REFERENCES

Manuel, Zenaida Vera-Cruz, 21st Century Accounting Process Basic Concepts and
Procedures, 24th edition, 2018;
Zeus Vernon B. Millan, Financial Accounting & Reporting – Fundamentals, 2019 2nd edition

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https://www.academia.edu/38227827/Fundamentals_of_Accounting_2_draft

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https://www.slideshare.net/sheisirenebkm/gas-12-branches-of-accounting)

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https://www.accountingformanagement.org/types-branches-of-accounting/
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https://www.accountingformanagement.org/explanation/accounting-principles-and-
concepts/
https://www.accountingformanagement.org/classification-of-accounts/
https://www.accountingformanagement.org/chart-of-accounts/
https://www.accountingformanagement.org/accounting-equation/
https://www.accountingformanagement.org/expanded-accounting-equation/

https://www.accountingformanagement.org/business-transaction/
https://www.accountingformanagement.org/double-entry-system-of-accounting/
https://www.accountingformanagement.org/rules-of-debit-and-credit/
https://www.accountingformanagement.org/general-journal/
https://www.accountingformanagement.org/general-ledger/
https://www.accountingformanagement.org/trial-balance/
https://www.accountingformanagement.org/adjusting-entries/
https://www.accountingformanagement.org/adjusted-trial-balance/
https://www.accountingformanagement.org/preparation-of-financial-statements/
https://www.accountingformanagement.org/balance-sheet/
https://www.accountingformanagement.org/income-statement/
https://www.accountingformanagement.org/closing-entries/
https://www.accountingformanagement.org/post-closing-trial-balance/
Retrievable from:
http://eeedrmcet.zohosites.com/files/IV%20Year/SEM%207/POM/POM_L9.pdf