Financial Accounting and Reporting Part 1 a MODULE 4 REVIEW OF THE ACCOUNTING PROCESS Overview The module gives us a review of the accounting process for single proprietorship both in service and merchandising business. Module Objectives At the end of this module, the students should be able to: Understand the definition of accounting and identify the users of accounting information. Identify and explain the steps in the accounting process Prepare adjusting entries and understand the rationale for their preparation. Prepares closing and reversing entries and understand the rationale for their preparation: 5. Prepare a financial statement for service and merchandising business. AOha ACCOUNTING DEFINED Accounting is a service activity. Its function is to provide quantitative information, primarily financial in nature, about economic entities, that is intended to be useful in making economic decisions, in making reasoned choices among alternative courses of action. This definition stipulates the nature and purpose of accounting. An accountant provides services and furnishes quantitative information expressed in terms of money that is useful to the users of the accounting information. The information are outlined into reports called financial statements and served as a basis for making important economic decisions. The users of the accounting information are categorized as either internal or external users. External users are decision makers who have no direct access to the information provided by the operations of the company. Intemal users represent the managers or the decision makers of an entity and they need the accounting information for the continued operation of their business. Examples of users and their need for accounting information as the basis for their decision making are: a. Investors are influenced with the retums from their investments and to decide whether to make additional investments, hold or sell their shares of stocks. b. Creditors/Suppliers/Lenders need accounting information to help in their decision whether to extend credit or loans being applied by businesses, ©. Government and their agencies need to know if an entity is abiding the implemented government rules and regulations.as Financial Accounting and Reporting Part 4 d. Employees/Labor unions are interested in the stability and profitability of the company they are working with and for the assurance of their security of tenure, . General Public and Customers need to know if the company would provide them continuity of their services and updates on improvements of their products and services BRANCHES OF ACCOUNTING There are two main branches of accounting: Financial Accounting and Management ‘Accounting Financial Accounting is designed in providing accounting information for all parties external to the operating responsibility of the company. It is the process of preparing accounting reports known as financial statements that show the company's financial performance and position to people outside the company like creditors and customers. Management or Managerial Accounting is designed in providing accounting information and operational needs for use by the internal users, the management. It involves financial analysis, budgeting and forecasting, cost analysis, and evaluation of business decisions. AREAS OF ACCOUNTING ‘Accounting is commonly misinterpreted and understood as just the recording of business transactions, known as bookkeeping. However, bookkeeping is only one of the functions of accounting while accounting is a diversified profession. Accountants can be employed in four broad or specialized areas: Public Accounting Public accounting offers accounting and related services to its clients on a fee basis. Some of the services being offered include preparation, review and audit of the company's financial statements, tax services, and consultation involving accounting systems, mergers and acquisitions. Accountants practicing public accounting are licensed professionals known as Certified Public Accountants Private Accounting Private accounting offers accounting services for a specific company and is an important part to the success of any organization. Private accountants offer a higher level of services through familiarity with the full workings of the company's business interests. They are concerned with the collection and analysis of financial data within a specific company. They are also involved with strategic planning and developing new products and services. Government Accounting Under Section 109, of the PD No. 1445, Government Accounting is defined as one that ‘encompasses the process of analyzing, classifying, summarizing and communicating all transactions that are involved in the receipt and disbursement of all government funds and properties, and interpreting the results thereof. Its objectives were set to include several areas,Financial Accounting and Reporting Part 1 PT in government operations. The accounting data should show how government funds were used and should indicate the outflow and inflow of funds and the need for a study of fund management and control, if necessary. Accounting Education ‘Accounting Education is an area of accounting that covers the upgrading, researching and teaching accounting knowledge to students, aspiring accountants or accounting professionals seeking continuous education and updates. This area is composed of accountants (Certified Public Accountants) who are into teaching, training and development, including research. — Accountants in education pursue a career as a faculty member in a school, an author of an accounting book, a researcher, a trainer, or a reviewer. FORMS OF BUSINESS ORGANIZATION The most common forms of business organization are the following Sole Proprietorship Sole or Single Proprietorship is organized and owned by only one person. It is easy to form and offers complete control to the owner. However, he is also personally liable for all financial obligations and debts of his business. Partnership A partnership is formed by two or more individuals who agreed to carry on a trade or business. Each individual contributes money, property, labor or skill, and expects to share in the profits of the business, Corporation ‘A Corporation is a more complex form of business organization as differentiated from a sole proprietorship and a partnership. It is a separate legal entity whose ownership is divided into shares of stocks. Its owners are known as shareholders. It is also subject to more legal requirements and government regulations, TYPES OF BUSINESS ACTIVITIES A business is an organization that uses basic resources (inputs) like materials and labor to provide goods or services to customers or clients, There are three major types of business: Service Business A service type of business provides services rather than products to customers or clients for a fee, Examples are salons, repair shops, hotels and restaurants, and professional firms like law and accounting, Merchandising Businessas Financial Accounting and Reporting Part 4 This type of business is also called a trading business. Merchandising companies buy goods in salable form and sell them to their customers at a higher cost to make a profit. Examples are department stores, bookstores, appliance stores and other resellers, Manufacturing Business This type of business buys raw materials with the intention of using them in making a new product, Manufacturing companies converts these raw materials into finished products before selling them to their customers. GENERALLY ACCEPTED ACCOUNTING PRINCIPLES (GAAP) Generally accepted accounting principles are a common set of accounting principles, standards and procedures that must be followed when preparing financial statements. Because it is important that all who will receive accounting reports be able to interpret them, a set of practices were developed that will provide guidelines for financial accounting. The term used to describe these practices is generally accepted accounting principles (GAAP) Generally accepted accounting principles encompass the conventions, rules, and procedures necessary to define accepted accounting practice at a particular time. These “principles” are not like the unchangeable laws of nature found in chemistry or physics. They are developed by accountants and businesses to serve the needs of decision makers, and they can be changed or altered as better methods are developed or as circumstances change A few examples of these generally accepted accounting principles are 1. Business Entity Concept Under the business entity concept, the activities of a business are recorded separately from the activities of the owner or owners. This concept is important because it limits the economic data in the accounting system to data related directly to the activities of the business. Thus, the accountant for a business with one owner (a proprietorship) would record the activities of the business only, not the personal activities, property, or debts of the owner. 2. Going Concern or Continuity Assum, To prepare financial statements for an accounting period, the accountant must make an assumption about the ability of the business to continue. Specifically, the accountant assumes that unless there is evidence to the contrary, the business entity will continue to operate for an indefinite period. This method of dealing with the issue is called the going concern or continuity assumption. The justification for all the techniques of income measurement rests on this assumption of continuity 3. Time Period Assumption The operating results of any business cannot be known with certainty until the company has completed its life span and ceased doing business. But financial reports covering shorter time periods are needed because external decision makers require timely accountingFinancial Accounting and Reporting Part 1 a information to satisfy their analytical needs. Because of this, businesses have imposed the time-period assumption, requiring that changes in a business's financial position be reported over a series of shorter time periods like annually, semi-annually, quarterly or monthly. An annual accounting period is the most common which can be a calendar year or a fiscal year. Example: January 1, 2017 to December 31, 2017 is a calendar year; July 1, 2017 to June 30, 2018 is a fiscal year. 4, Unit-of-Measure Assumption The unit-of-measure assumption specifies that accounting should measure and report the results of a business's economic activities in terms of a monetary unit such as the Philippine peso, The assumption recognizes that the use of a standard monetary unit throughout all financial statements is an effective means for aggregating and communicating accounting information. It is a standard practice to ignore changes in the purchasing power of a peso. ACCRUAL BASIS AND CASH BASIS OF ACCOUNTING The difference between accrual basis and cash basis of accounting lies in the timing of when is revenues and expenses are recognized and incurred when recorded in the books. Under the cash basis of accounting, revenues are recognized and recorded when cash is received or collected and expenses when cash is paid. No adjusting entries are needed in this method of accounting Under the accrual basis of accounting, revenues are recognized and recorded when eared regardless of when cash is received or collected. Expenses incurred are recorded Whether or not cash is paid. Adjusting entries are needed under this method to update the account balances at the end of the accounting period, ‘THE ACCOUNTING CYCLE The accounting cycle, also known as the accounting process, refers to a series of steps accountants perform during an accounting period for the orderly accumulation, reporting and interpretation of data pertaining to the financial operations of the business. The functions of accounting can be summarized as the recording, classifying, summarizing and interpreting of business data, The first three functions represent the process by which accounting information is developed. These steps are applied in accordance with generally accepted accounting principles and practices developed by the accounting profession. The interpreting function involves the use of analytical techniques and procedures as a base for management decisions. The steps in the accounting cycle include the following: Documentation Journalizing Posting Preparation of the trial balance Compilation of data needed for adjustments Preparation of the worksheet Preparation of the Financial Statements Adjusting entries are journalized and posted to the ledger Closing entries are journalized and posted to the ledger ©ONOMRON>so | Financial Accounting and Reporting Part 4 10. Preparation of the post-closing trial balance 11, Reversing entries are journalized and posted to the ledger The first three steps constitute the recording phase of accounting. The summarizing phase begins with the trial balance preparation up to the post-closing trial balance. Reversing entries prepared on the first day of the next accounting period is considered to be an optional step. RECORDING PHASE ‘Accounting is based on a double entry system which means that a business transaction has a dual effect when recorded. Business transactions are recorded in at least two accounts. Documents are needed to serve as a basis for recording the transactions, The two books of accounts where transactions are recorded are the journal and the ledger. The double-entry accounting system has specific rules of debit and credit for recording the transactions in the accounts. Debit is the left side of an account while credit is the right side. To summarize the rules of debit and credit: Debit: Credit: Increases in assets * Decreases in assets Decreases in liabilities * Increases in liabilities Decreases in equity/capital + Increases in equity/capital © drawings + investments © decrease in revenue * increase in revenue * increase in expense © decrease in expense Applying the rules of debit and credit, transactions are first recorded in the book of original entry called the general journal and the process is known as journalizing. The chart of accounts should show the elements of the financial statements which shall be used in recording the transactions. Special journals are sometimes used by businesses that are designed for recording a single type of transaction that occurs frequently. The format and the number of special journals used will depend on the nature of the business. The most common special journals include the cash payments journal, cash receipts journal, revenue/sales journal and the purchases journal. The general journal will be used for entries that cannot be recorded in the special journals such as adjusting and closing entries. The information from the journal is then transferred to the book of final entry called the general ledger and the process is called posting. The ledger is a complete listing of all the accounts as found in the chart of accounts of a business. The purpose of this process is to classify the effects of transactions on the elements of the financial statements. Businesses may have control accounts and subsidiary ledgers that will show their balances are the same. Subsidiary ledger is a group of related accounts showing the details of the balance in the control account. Examples of control accounts are Accounts receivable and Accounts payable accounts.Financial Accounting and Reporting Part 1 a SUMMARIZING PHASE After all the transactions are posted in the ledger, the account balances are then computed and must show the normal balances of each individual account. The preparation of the trial balance will mathematically prove the equality of the debit and credit balances of each account but will not give the assurance that no errors have been made during the journalizing and posting process in case the total debit and credit amounts are shown as equal. Inequality in the debit and credit totals would automatically prove the presence of an error. The most common examples of errors showing inequality of total debit and credit amounts are transposition and slide. Transposition is the erroneous rearrangement of writing an amount like P 1,250 written as P 1,520. Slide is an error in which the whole amount is moved one or more spaces to the right or the left, like P 1,000 written as P 100 or P 10,000. At the end of the accounting period, some of the account balances presented in the trial balance are not yet updated and may require adjustments before financial statements are prepared. Data for adjustments are then compiled for such updating. The types of accounts that require adjustment are as follows: 1. Prepaid Expenses — These are expenses paid by the business in advance; or these are ‘expenses already paid in cash by the business but the expenses are not yet incurred or only a portion of the amount paid was used up as expense. Prepaid expenses are also termed as deferred expenses. There are two methods of accounting for prepaid expenses: ‘a. Asset method ~ if at the date of payment, the business debited an asset account. The pro-forma adjustment is: Expense Account xxx Compute used or expense Asset Account 00 as portion b. Expense method — if at the date of payment, the business debited an expense account. The pro-forma adjustment is: Asset Account Xxx ‘Compute unused or asset Expense Account wx portion To illustrate, assume that Lakers Company is using a monthly accounting period. On January 1, 2017, the company paid P 30,000 representing 3-month rent beginning January 1, 2017. The company adjusts and closes its books every month. The entry to record the prepayment and the adjusting entry at the end of the month will be: Asset Method Expense Method 2017re Financial Accounting and Reporting Part 1 Jan 1 PrepaidRent 30,000 Rent Expense 30,000 Cash 30,000 Cash 30,000 31 Rent Expense 10,000 Prepaid Rent 20,000 Prepaid Rent 10,000 Rent Expense 20,000 Since P 30,000 is for 3 months, the monthly rent is P 10,000. For January, the used or ‘expense portion is one month or P 10,000; therefore the unused or asset portion will be two months or P 20,000 as of January 31 Regardless of which method a business used in any particular case, the amount reported as expense in the income statement and the amount reported as asset in the balance sheet will be the same. Both methods of accounting for prepayment are acceptable although most companies employ the expense method due to its simplicity. A business must also use a method consistently for a particular type of prepayment, say asset method for rent while expense method for supplies. 2. Unearned Revenues - These are revenues collected or received by the business in advance: or these are revenues already collected in cash by the business but the revenues are not yet earned or only a portion of the amount received was earned or became revenue. Uneamed revenues are also termed as deferred revenues. There are two methods of accounting for unearned revenues: Liability method — if at the date of collection, the business credited a liability a. account, The pro-forma adjustment is: Liability Account 20% Compute eamed or income Revenue Account xox portion b. Revenue method ~ if at the date of collection, the business credited a revenue account. The pro-forma adjustment is: Revenue Account xxx Compute unearned or liability Liability Account xx portion To illustrate, assume that Miami Company is using a monthly accounting period. On January 1, 2017, the company collected or received P 30,000 representing 3-month rent beginning January 1, 2017. The company adjusts and closes its books every month. The entry to record the advance collection and the adjusting entry at the end of the month will be:Financial Accounting and Reporting Part 1 a bility Method Revenue Method 2017 Jan 1 Cash 30,000 Cash 30,000 Uneamed Rent 30,000 Rent Income 30,000 31 Uneamed Rent — 10,000 Rent Income 20,000 Rent Income 10,000 Unearned Rent 20,000 Since P 30,000 is for 3 months, the monthly rent is P 10,000. For January, the earned or income portion is one month or P 10,000; therefore the unearned or liability portion will be two months or P 20,000 as of January 31 Regardless of which method a business used in any particular case, the amount reported as income in the income statement and the amount reported as liability in the balance sheet will be the same. Both methods of accounting for unearned or deferred revenues are acceptable although most companies employ the revenue or income method due to its simplicity. A business must also use a method consistently for a particular type of unearned or deferred revenue, say liability method for rent while income or revenue method for subscription 3. Accrued Expenses — These are expenses incurred in one period but remain unrecorded and unpaid as of the end of the period. They are also called accrued liabilities or unrecorded expenses. The pro-forma adjustment is: Expense account xx Liability account xxx For example: A company's accounting period is monthly, January 1-31, 2017. All expenses incurred during the month of January must be recorded in January. Let us say, telephone bill for the month of January amounting to P 5,000 will be paid on February 5, 2017. the adjusting entry will be 2017 Jan 31 Utilities Expense 5,000 Utilities Payable 5,000 So, since we are using the accrual basis of accounting, the question is when did the company incur the expense? The answer of course is for the month of January, therefore we will record the expense in January. And since this will still be paid in February, we will record a liability in January. Another example is, assume a small business is paying a total of P 10,000 for the wages of its employees for a 5-day work week. Payday is every Friday. Accounting period is monthly. The Wages Expense during the month of March is shown below:Financial Accounting and Reporting Part 4 Mar.5 10,000 12 10,000 19 10,000 26 — 10,000 40,000 If March 26 is a Friday, then the last day of the month (March 31) falls on a Wednesday. Therefore the adjusting entry to be made will be: Mar. 31 Wages Expense 6,000 Wages Payable 6,000 If financial statements are prepared on March 31, the Wages Expense to be shown in the income statement totaled P 46,000 and the balance sheet will show Wages Payable amounting to P 6,000. 4. Accrued Revenues — These are revenues eared in one period but remain unrecorded and not received as of the end of the period. They are also called accrued assets or unrecorded revenues. The pro-forma adjustment is: Asset account Xxx, Revenue account od For example: ABC Company's accounting period is monthly, August 1-31, 2017. All revenues earned during the month of August must be recorded in August. If the company is in the business of renting apartments and one of its tenants has not paid the August rent for P 8,000, then the adjusting entry of ABC Company will be: 2017 Aug. 31 Rent Receivable 8,000 Rent Revenue 8,000 5. Depreciation of Property, Plant and Equipment Physical resources that are owned and used by a business which are permanent in nature or have a long useful life are called fixed assets or plant assets. Examples are land, building, equipment, trucks, automobiles, a computer, store fixtures, or office furniture. These assets help generate income for the business, Therefore it is important and proper that a portion of the asset be recorded as expense in each accounting period, Fixed assets, with the exception of land have limited useful ives and as such are subject to depreciation Depreciation is the systematic allocation of the cost of the fixed asset over its useful life. Depreciation is not a process of asset valuation.Financial Accounting and Reporting Part 1 The pro-forma adjustment for depreciation is: Depreciation Expense — Name of asset Xxx ‘Accumulated Depreciation - Name of asset 20x There are different methods of computing depreciation. We will discuss here only the simplest and the most commonly used method which is the straight-line method. This method will result into equal periodic charges for depreciation, Also take note that in the adjusting entry for depreciation, the account credited is the account Accumulated Depreciation. This is a contra-asset account which will be deducted from the related fixed asset account in the balance sheet. The credit is not made directly to the fixed asset account in order to preserve the original cost of the fixed asset in the balance sheet. To illustrate, assume that on January 1, 2017, Knicks Company bought a delivery truck for a total cost of P 500,000. Its estimated life is 10 years and the estimated residual value is P.50,000. The company is using the straight-line method of computing depreciation and it is using an annual accounting period. The entries of Knicks Company for the above transactions are 2017 Jan 1 Delivery Truck 500,000 Cash 500,000 To record the purchase of delivery truck The adjusting entry on December 31, 2017: 2017 Dec 31 Depreciation Expense-Delivery Truck 45,000 Accumulated Depreciation-Delivery Truck 45,000 Computations will be: Annual depreciation = Cost Residual Value Estimated Life P.500,000 — 50,000 70 P 45,000 Other computation for straight-line method is: Annual depreciation = — (Cost— Residual Value) x Depreciation Rate (P 500,000 — 50,000) x 10% P 45,000Financial Accounting and Reporting Part 4 The depreciation rate can be computed by getting the reciprocal of the life. Example: 10 years is equal to 1/10 or 10%, The balance of the Depreciation Expense account is shown in the income statement. In the balance sheet as of December 31, 2017, the carrying amount or the book value of the asset is P 455,000, as shown below: Delivery Truck P 500,000 Less Accumulated Depreciation 45,000 Carrying amount or Book value P_455,000 The depreciation of the fixed asset will be recorded at the end of each year (for ten years). The same adjusting entry will be recorded for 10 years. Assuming a balance sheet will be made on December 31, 2022: Delivery Truck P 500,000 Less Accumulated Depreciation 270,000 Carrying amount or Book value __P_230,000 At the end of ten years, the Accumulated Depreciation account will have a balance of P 450,000. At this point, the book value of the asset will be equal to the residual value of P 50,000. 6. Uncollectible accounts — these are estimated amounts due from customers that may no longer be collected and are considered to be as bad debts, The allowance method estimates the amount of uncollectible accounts receivable and will be recorded as an adjusting entry at the end of the accounting period and follows the matching principle. The pro-forma adjustment is: Doubtful Accounts Expense Xxx, Allowance for Doubtful Accounts XXX Since the loss is an estimate only and the specific customer cannot be identified at this, point, the Accounts Receivable may not be credited. Instead a contra asset account, Allowance for Doubtful Accounts, is credited, The Doubtful Accounts Expense is also called Bad Debts Expense or Uncollectible Accounts Expense. The Allowance for Doubtful Accounts is also called Allowance for Bad Debts or Allowance for Uncollectible Accounts. The estimate of uncollectible amount at the end of the accounting period is based on past experience and forecasts of the future. This is computed based on the Accounts Receivable balance wherein: a. Single rate is applied to outstanding accounts receivable orFinancial Accounting and Reporting Part 1 a b. Aging of accounts receivable where accounts are classified according to how long they remain outstanding The computation for the estimated Doubtful Accounts Expense is shown as Required ending balance of Allowance for Doubtful P xxx Accounts Allowance for Doubtful Accounts before adjustment ‘add if debit balance/deduct if credit balance) 00K Doubtful Accounts Expense for the period P xxx As an example, the following accounts were found in the ledger of Cavs Red Enterprises on December 31 of the current year: Debit Credit Accounts Receivable 187,520 Allowance for Doubtful Accounts 10,680 Net Sales 4,272,000 The estimated doubtful accounts at the end of the current year is 10% of the outstanding Accounts Receivable. The adjusting entry on December 31 is as follows: Doubtful Accounts Expense 8,072 Allowance for Doubtful Accounts 8,072 Required ending balance of Allowance for Doubtful Accounts P18,752 (10% x P 187,520) Less credit balance of allowance before adjustment Doubtful Accounts Expense for the period 7. Merchandise Inventory- these represents good on hand and available for sale in the ordinary course of the business. If the company is using the periodic inventory system, adjusting entries are required to replace or remove the beginning balance of the merchandise inventory with the balance at the end of the accounting period. The adjusting entries to record the replacement of the beginning merchandise inventory balance and to enter the ending inventory balance would be’ Income Summary 20% Merchandise Inventory xxx To close the beginning inventory Merchandise inventory Xxx Income Summary 7x To record the ending inventoryTs Financial Accounting and Reporting Part 4 Under the perpetual inventory method, purchases and sale of goods are recorded in the merchandise inventory account and the cost of goods sold account. As a result, the balances of the merchandise inventory and the cost of goods accounts are always updated, After all the adjustments are compiled, the next step is the preparation of the worksheet. This is an optional step in the accounting cycle. However, it is useful in showing the flow of the accounting information from the unadjusted trial balance to the adjusted trial balance and in analyzing the impact of such adjustments on the financial statements. A worksheet is a working paper prepared by an accountant to facilitate the preparation of the financial statements. After the completion of the worksheet, financial statements are prepared and serve as the primary means of communicating important accounting information to users, These are accounting reports that quantify the financial strength, performance and liquidity of a business. Financial statements represent the final output in the work of an accountant. They include Statement of Comprehensive Income, Statement of Changes in Equity, Statement of Financial Position, the Cash Flow Statement and Notes to the Financial Statements. The Statement of Comprehensive Income, also known as the Profit and Loss Statement, presents the income, expenses and the operating result (profit or loss) during an accounting period. The Statement of Changes in Equity shows the summary of changes (increases or decreases) affecting the equity of the owner/s during an accounting period. The Statement of Financial Position, also known as the Balance Sheet, shows the financial condition of the business as of a specific date. It helps the users in assessing the financial soundness of business in terms of liquidity risk, financial risk, credit risk and business risk. The Cash flow Statement presents the movement of cash (input and output) over a period and is classified as either under operating, financing or investing activities The Notes to the Financial Statements are an integral part of an entity's financial statements. They are for complying with the full disclosure principle. The adjusting and closing entries are entries prepared and posted in the ledger at the end of the accounting period. The adjusting entries are prepared after the data for adjustments are compiled and presented in the worksheet. Accounts in the ledger are classified as nominal or temporary accounts and real or permanent accounts. Nominal accounts include revenue, expense, owner's drawing and income summary accounts. Real or permanent accounts include the assets, liability and the owner's equity (capital) accounts Closing entries are prepared to reduce the nominal account balances to zero on the general ledger. The revenue and expense account balances are transferred to the Income Summary account. The Income Summary balance is then transferred to the owner's equity or capital account. A credit balance in the Income Summary indicates the profit while a debit balance indicates a net loss. The owner's drawing account is also transferred in the owner's capital account. The following entries show how the closing process is made:Financial Accounting and Reporting Part 1 1. Revenue 2x Income Summary 7x To close revenue accounts 2. Income Summary 290% Expenses xxx To close expense accounts *3, Income Summary with a credit balance: Income Summary 290% Owner's Capital xxx To close income summary account “Income Summary with a debit balance: Owner's Capital 2x Income Summary xxx To close income summary account Owner's Drawing ing, bt} The post-closing trial balance is a list of accounts and their balances after the closing entries have been joumalized and posted to the ledger. It includes all the real accounts since the nominal account balances have been reduced to zero. The purpose of the post-closing trial balance is to verify that all nominal accounts have been closed properly and the total debits and credits in the accounting system are equal after the closing process, Reversing entries are journal entries prepared on the first day of the next accounting period which reverses certain types of adjusting entries immediately made in the preceding period. The adjusting entries that may be reversed include the accruals, prepaid expense using the expense method and uneamed revenue using the revenue method. This step is an optional procedure and is useful to simplify record keeping in the next accounting period. The rule to follow is all adjusting entries that increase an asset or liability will be reversed. Whether reversing entries are made or not, the same result is achieved, The following show reversing entries that are made on the first day of the next accounting period: 1. Prepaid expense using expense method Expense 2x Prepaid Xxx Expense/Asset 2. Unearned revenue using revenue method Unearned revenue 2x Revenue Xxxa Financial Accounting and Reporting Part 1 3. Accrued expense Payable 70x Expense 00x 4. Accrued Revenue Revenue 20x Receivable 20x THE ACCOUNTING PROCESS ee journal are) tty i Porn fees rer foamy oe peveinyFinancial Accounting and Reporting Part 1 MERCHANDISING BUSINESS The activities of a service business differ from that of a merchandising business. A service business eams revenue by rendering services to customers or clients. The revenue activities of a merchandising business involve the buying and selling of goods or merchandise to its customers. However, except for the merchandise related accounts, the accounting cycle for both types of business activities are the same. Because of the differences in their revenue activities, the general format of the condensed statements of comprehensive income of service and merchandising companies are illustrated below: Service Business Merchandising Business Service Revenue P Sales P 7x Xxx Less Operating Less Cost of Merchandise Expenses xx Sold 20x Net Income Gross Profit 2x Xxx Less Operating Expenses 2x Net Income xxx INVENTORY SYSTEMS The two main types of inventory systems are the periodic inventory system and the perpetual inventory system. Companies that sell goods of low unit value or inexpensive items Use the periodic inventory system. The periodic system relies upon the physical count of the inventory to determine the ending inventory balance. Merchandise bought intended for sale are recorded in the Purchases account. The balance in the Purchases account is then added to the beginning balance of the inventory account to arrive at the cost of merchandise available for sale. When a physical inventory count is done, the amount of the ending inventory balance will then be deducted from the cost of merchandise available for sale to arrive at the cost of merchandise sold. Sale of merchandise is recorded in a revenue account, Sales. However, the cost is not recorded. Under the perpetual inventory system, purchases and sale of merchandise is recorded in the Merchandise Inventory account and the Cost of the Merchandise Sold account. This system is used by companies that sell goods of high unit value like automobiles, jewelry, and other large home appliances. The business Keeps track of its cost of merchandise sold on a continuous basis, thus, at any given time, there is an estimate of the company's inventory level. At the end of the accounting period, an actual count is taken on the number of units still on hand and is compared with the records showing the ending inventory balance. VALUE ADDED TAX Value Added Tax (VAT) is a type of sales tax which is levied on the consumption on the sale of goods, services or properties, as well as goods imported in the Philippines.Te Financial Accounting and Reporting Part 1 ‘A 12% value added tax rate is levied on goods and is recorded as a separate account in recording the sale and purchase transactions. It is an indirect tax that is passed on to the buyer and is added to the selling price. The amount paid by the customer, known as the invoice price, will include the selling price and the 12% value added tax. Output Vat refers to the value added tax the seller passed on to the buyer and is classified as a liability account. Input Vat refers to the value added tax the buyer paid on the purchase. The excess of output tax over input tax is the Value added tax due and payable to the Bureau of Internal Revenue and is to be remitted by the company within 25 days of the following month, The following transactions illustrate the accounting for value added tax using the periodic system: Mar5 A Company sold merchandise to B Company for cash, P 22,400 vat inclusive. ACompany B Company Cash 22,400 Purchases 20,000 Sales 20,000 Input tax 2,400 Output tax 2,400 Cash 22,400 Mar 6 A Company sold merchandise on account to X Company, P 28,000 vat inclusive ACompany X Company Accounts Receivable 28,000 Purchases 25,000 Sales 25,000 Input tax 3,000 Output tax 3,000 Accounts Payable 28,000 Mar9 A Company issued a credit memorandum to X Company for defective merchandise retumed sold on March 6, invoice price P 2,800 ACompany X Company Sales retums and 2,500 Accounts Payable 2,800 allowances Output tax 300 Purchase ret. and 2,500 allow. Accounts 2,800 Input tax 300 Receivable Mar 15 A Company collected amount due from X Company A Company X Company Cash 25,200 Accounts Payable 25,200 Accounts 25,200 Cash 25,200 Receivable SPECIAL JOURNALS We have used the general journal to record all types of business transactions. However, as the transactions of a company increase, there is a need to change to a more efficient and timesaving manner. Accountants have developed an accounting system for an orderly and effective processing of data, They have developed special joumnals, Each special journalFinancial Accounting and Reporting Part 1 a records one particular type of transaction that occurs frequently, such as sales on account, cash receipts, purchases on account, or cash disbursements, The special journals are designed to systematize the original recording of major recurring types of transactions. The number and format of the special journals actually used in a company depend primarily on the nature of the company's business transactions. The special journals commonly used by merchandising companies include the sales, cash receipts, purchases, cash disbursements journals. The Sales Journal is used to record all sales of merchandise on account (an credit). The Cash Receipts Journal is used to record all inflows or receipts of cash into the business. ‘+ The Purchases Journal is used to record all purchases of merchandise and other items on account (on credit) ‘+ The Cash Payments Journal is used to record all payments (or outflows) of cash by the business. Although all these four special journals are being used, the General Journal is still needed. The General Journal is used to record all transactions that cannot be recorded in any one of the special journals. All five of these journals are books of original entry. If a transaction is recorded in the journal, it is posted to the ledger and made part of the accounting records. Therefore, if a transaction is recorded in a special journal, it should not be recorded in the general journal because this would record the transaction twice. Since the journal entries are posted to the ledger accounts, the posting reference column in the ledger should indicate the source of the posting. The following abbreviations are used for the five journals: Journal Transactions Abbreviation Sales Journal Merchandise sold on account s Cash Receipts Journal Cash receipts from all sources cR Purchases Journal Merchandise and other items purchased on account P Cash Payments Journal Cash payments for various purposes cp General Journal Any transaction that is not included in the special G. journals. CONTROL ACCOUNTS AND SUBSIDIARY LEDGERS A control account is an account in the general ledger that shows the total balance of all the subsidiary accounts related to it, An example of a control account is the general ledger Accounts Receivable account, which summarizes all of the amounts owed to the company The subsidiary ledger accounts show the details supporting the related general ledger control account balance, The company may use subsidiary accounts for receivables to send out customer statements. They may use the subsidiary accounts for payables to determine the amount payable to each supplier. These accounts are normally arranged alphabetically by the name of the customer or supplier. The sum of the subsidiary accounts in a subsidiary ledger should agree with the balance in the related general ledger control account when the company prepares the financial statements.Ts Financial Accounting and Reporting Part 4 A subsidiary ledger, then, is a group of related accounts showing the details of the balance of a general ledger control account. The subsidiary ledger is separated from the general ledger in order to relieve the general ledger of a mass of details and thereby shorten the general ledger trial balance. Also, having separate ledger promotes a division of labor. ‘SCHEDULE OF ACCOUNTS PAYABLE A schedule of accounts payable is prepared to make certain that the total of the balances in the subsidiary ledger accounts agrees with the control account. SCHEDULE OF ACCOUNTS RECEIVABLE A schedule of accounts receivable is prepared to ensure that the total of the balances in the subsidiary ledger account agrees with the control account. This schedule is merely a listing of open account balances. Readings * Chapter 1, Accounting for Partnership and Corporation, 2011 Ealition, Gloria J Tolentino- Baysa and Ma. Concepcion Yamat Lupisan