Accounting Cycle Notes PDF

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Warning: TT: undefined function: 32 Warning: TT: undefined function: 32Accounting for Service BusinessSTEPS in the ACCOUNTING CYCLE 1. Analyzing 2. Journalizing 3. Posting to the Ledger 4. Trial Balance 5. Adjusting 6. Financial Statements 7. Closing 8. Post-Closing Trial Balance 9. ReversingSERVICE...

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Accounting for Service Business STEPS in the ACCOUNTING CYCLE 1. Analyzing 2. Journalizing 3. Posting to the Ledger 4. Trial Balance 5. Adjusting 6. Financial Statements 7. Closing 8. Post-Closing Trial Balance 9. Reversing SERVICE BUSINESS Renders services to clients or customers to generate revenues Uses Service Revenue account or specific account such as Photocopying Revenues or Printing Revenues STEP 1: ANALYZING requires familiarity with business documents (e.g., official receipts, sales invoice, statements of account or billing statements, deposit slips, payroll sheets, debit or credit memo) How to? a) Classify whether the transaction is a business or a non-business transaction. If it is the latter, no need to proceed to step 2. b) Identify the accounts affected and the movement with respect to its normal balance/s. c) Determine whether the account is increased or decreased. d) Determine the amount to be debited or credited. Example: Mr. Mercado invested cash of P30,000 in his business to be known as JM Photocopying Center. Using the analysis: a) Business transaction b) Accounts affected: Cash (asset) Mercado, Capital (owner’s equity) c) Increase in both accounts d) Amount to be debited is P30,000 for cash (debit being the normal balance) and credit is P30,000 for Mercado, Capital (credit being the normal balance) STEP 2: JOURNALIZING process of entering a business transaction in the form of an accounting entry in the “journal” or the so-called “book of original entry.” A journal is where business transactions are initially recorded chronologically. Can either be simple or compound. A simple journal entry: one debit account and one credit account.

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Example: On August 1, 2018, Mr. Mercado invested cash of P30,000 in his business to be known as JM Photocopying Center.

STEP 3: POSTING TO THE LEDGER ledger contains all the accounts (assets, liabilities, owner’s equity, revenues, and expenses) maintained by the business. Posting refers to the procedure of transferring information in the journal to the ledger accounts. Each account title in the chart of accounts has its own ledger. It captures all the movement (increase/decrease) in each account which were initially reflected in the journal. Arranged in the order in which accounts are presented in the financial statements starting with the balance sheet accounts followed by the income statement accounts. ▪ One ledger for client A, another for client B ▪ Subsidiary ledger is per customer or supplier. ▪ One journal entry → at least two ledgers are affected STEP 4: PREPARING THE TRIAL BALANCE From the ledger, accounts with balances will be summarized in a trial balance. A trial balance is a list of accounts and their balances at a given time. It shows the equality of debits and the credits. Accounts are listed in the same manner they appear in the ledger, with accounts having zero balances skipped. Steps: a) Indicate the heading (centered) the details of the trial balance (name of the business, the term “Trial Balance ” or “Worksheet” and the date. b) List the open accounts and their balances. c) Total the debit and credit columns d) Double-rule the totals of the debit and credit columns. ERRORS NOT CAUSING “UNBALANCED” TRIAL BALANCE Balanced trial balance (TB) does not prove accuracy of trial balance. Example of errors still resulting to a balanced TB: 1.

Transaction is completely omitted (Error of Omission) Example: a. If the payment P2,000 to a supplier has been omitted, then correcting entry would be: Accounts Payable Cash

2,000 2,000

2.

A correct journal entry is not posted. Example:

Original entry: Cash

1,560 A/R

Correct entry: Cash

1,560

1,650 A/R

3.

Journal entry posted twice

1,650

Correcting entry: Cash A/R

90

Original entry: Notes Payable Cash

5,050

Correct entry: Notes Payable Cash

5,500

90

c.

4.

Complete Reversal of Entries - occurs when the correct amount is posted to the correct accounts but the debits and credits have been reversed. Example: Original entry: Sales

6. 400 Cash

Correct entry: Cash

400

5,500

Correcting entry: Notes Payable 450 Cash 450 Compensating Error - occurs when two or more errors cancel each other out. Example:

400 Sales

Correcting entry: Cash

400

800 Sales

5.

5,050

800

Error of Original Entry/Transposition Error - occurs when an incorrect amount is posted to the correct account Example: 7. a.

If cash paid to a supplier of P2,140 was posted as P2,410: Original entry/entry made: Accounts Payable 2,410 Cash

2,410

Original entry: Cash 3,000 Accounts Receivable - Cust. B 3,000

Correct entry: Accounts Payable 2,140 Cash

2,140

Correct entry: Cash 3,000 Accounts Receivable - Cust. A 3,000

Correcting entry: Cash 270 Accounts Payable 270 b.

Error of Commission - occurs when an item is entered to the correct type of account but to the wrong owner’s account. Example:

Correcting entry: Accounts Receivable - Cust B. 3,000 Accounts Receivable - Cust. A 3,000

8.

Incorrect account title used in journalizing (Error of Principle)

2. 3.

Examples: a. Original entry: Transportation expense Cash Correct entry: Taxes and Licenses Cash

370

370 370

Correcting entry: Taxes and Licenses 370 Transportation Expense

370

b. Original entry: Notes Payable Cash

5,000

Correct entry: Cash Revenue Correcting entry: Cash Notes Payable Revenue c. Original entry: Cash Salary expenses

9.

370

5,000

5,000 5,000

10,000 5,000 5,000

1,000 1,000

Correct entry: Cash Sales

1,000

Correcting entry: Salary expenses Sales

1,000

1,000

1,000

Offsetting errors

ERRORS CAUSING UNBALANCED TB Unbalanced TB is always wrong Steps: a) Locate the error. b) Correct the error. USUAL CAUSES: 1. Mathematical mistakes (wrong addition or subtraction; wrong computation)

Incorrect postings (posting on the wrong side of the account or incomplete posting) Incorrect transcription (error in transferring balance from the ledger)

LOCATING AND CORRECTING THE ERROR: A. Locating the error: determine the amount of difference between the two columns (debit and credit) B. Correcting the error: 1.) A difference of 1, 10, 100 or 1,000 in the balances could mean an error in addition or subtraction. As such, just re-add the trial balance columns. 2.) A difference that is divisible by 2 could mean an error in posting on the wrong side of the account. You can scan the trial balance to check whether a balance equal to half the difference has been posted on the wrong side. 3.) A difference that is divisible by 9 could mean transposition error. It could also be a slide error which results from misplacement of decimal point. Retrace the account balance on the trial balance to check whether there was error in transferring the balances to the ledger. 4.) A difference that is neither divisible by 2 nor 9 could mean an account balance has been omitted from the trial balance. As such, scan the ledger then the journal to check whether a posting or a journal entry has been omitted. *Tip: Locate from the TB first, then to the ledger, then to the journal. What does OVERSTATED mean? When an accountant uses the term overstated, it means two things: the reported amount is incorrect, and the reported amount is more than the true or correct amount. Example: If a company reports that its prepaid insurance is P8,000, but the true or correct amount of prepaid insurance is only $7,000, the accountant will say that the reported amount of prepaid insurance is overstated by $1,000. Because of double-entry accounting, if the balance in the account Prepaid Insurance is overstated (too much is being reported) it is likely that the account Insurance Expense will be understated (too little is being reported). What does UNDERSTATED mean? When an accountant says that an amount is understated, it means two things: the amount is not the correct amount, and the amount is less than the true amount. In other words, the amount is too small. To illustrate the term understated, let's assume that a company is reporting its accounts payable as P21,000. Let's also assume that the correct or true amount of accounts payable is

P23,000. An accountant will say that the reported amount of P21,000 is understated by P2,000. MORE EXAMPLES of CORRECTING ENTRIES: 1.

Entry made to record cash purchase of equipment worth P9,000: Dr. Cash, Cr. Equipment 9,000

2.

Entry to record P10,000 cash collection of receivable: Dr. Loans Receivable, Cr. Accounts Payable 10,000

3.

Entry made to pay utilities of P6,500: Dr. Utilities expense, Cr. Cash 5,600

STEP 5: ADJUSTING THE JOURNAL ENTRIES and the ADJUSTED TRIAL BALANCE Adjusting entries need to be prepared at the end of the accounting period to bring the ledger balance into amounts that are in adherence with the accrual principle Crucial in the preparation of accurate or fairly valued financial statements Common practice for an entity to recognize expense before payment, recognize income before receipt, and pay for an expense before it is incurred, or receive payment before it is earned. To adjust the book implies that the entity recognizes expenses, income, depreciation and bad debts accounts at the end of the accounting period to update the books because of the events that has transpired throughout the period. Adherence to accrual accounting and time-period principle Different from correcting -- done when there was an error made in the journal entry made (e.g., error of transposition or transplacement in the amounts of the journal entry) Revenue is recorded when earned; expense is recorded when incurred Applies also to depreciation and doubtful accounts ADJUSTING ENTRIES Entries required at the end of each accounting period to recognize on an accrual basis revenues and expenses for the period and to report proper amounts for assets, liabilities, and owner’s equity accounts One common characteristic of adjusting entries is that they affect at least one real account (assets, liabilities or equity accounts; accounts found or included in the statement of financial position) and one nominal account (revenue or expense account; accounts found or included in the income statement) INITIAL RECORDING: We have to make adjusting entries because businesses always make entries upon paying cash through checks and receipt of cash for the purposes of proper cash control. Thus, they use CASH BASIS of ACCOUNTING. Examples: advance payment/receipt of rent, insurance *Mixed Accounts - accounts which has the nature of both real and nominal accounts and are due for adjustments (e.g., prepaid rent account, sewing supplies, among others, before being adjusted at year-end are considered mixed accounts).

CASH BASIS vs. ACCRUAL BASIS Cash Basis - income is recorded when cash is received (no matter when it is earned) and expenses are recognized when paid (no matter when it is incurred). It is not compliant with GAAP and is much simpler than accrual basis but its financial statement results can be very misleading in the short run.

Accrual Basis - income is considered to be earned in the period of the sale (services – rendered, merchandise – delivered to customer) even if cash has not been received yet while expenses are considered to be incurred even if no cash has been paid yet. GAAP require that a business use this method.

b.

3. 4. 5.

Unearned/Deferred Income - cash received but not yet earned Depreciation Allowance for doubtful accounts - estimate of uncollectible Accounts Receivable Merchandise Inventory

INITIAL RECORDING of ASSETS and UNEARNED REVENUES

Pro forma entry: Asset/Receivable Revenue

Pro forma entry: Expense

xx xx

xx Liability/Payable

xx

Pro forma entry: LIABILITY METHOD Unearned Revenue Revenue REVENUE METHOD Revenue

xx

xx Unearned Revenue

TYPES OF ADJUSTMENTS/ADJUSTING ENTRIES: 1. Accruals a. Accrued Income - earned but not yet collected b. Accrued Expense - incurred but not yet paid 2. Deferrals a. Prepaid Expense - paid but not yet incurred

xx

xx

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Pro forma entry: ASSET METHOD Expense

xx Asset

EXPENSE METHOD Asset

xx

xx Expense

xx

DEPRECIATION -

-

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Systematic and rational allocation of the depreciable cost of an asset over its useful life and represent the future economic benefit that has been used in the period. Asset is expensed over the useful life. Its objective is to have each accounting period benefitting from the use of the asset bear an equitable share of the asset cost. Done for the basic purpose of achieving the matching principle (i.e., to offset the revenue of an accounting period with the cost of goods and services being consumed in the effort to generate that revenue)

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Methods of computing depreciation: a) b) c) d) e)

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Straight line method Accelerated methods Declining balance method Double declining balance method Sum of the years digit method

Recorded at the end of every accounting period in order to recognize the usefulness of any PPE asset, except land, may decline because of wear and tear or obsolescence. Computation of depreciation expense is an estimate rather than a factual measurement of the cost that has expired since the useful life of the asset is just purely an estimate. o Depreciation during the acquisition year may not be always equal to the yearly depreciation of the asset most especially if the asset was not acquired during the start (i.e., first month) of the accounting period. Accumulated Depreciation - a contra-asset account that shows the cumulative sum of all depreciation expense from the acquisition date of the asset until the current period

Contra-Asset account - an asset account but with a normal credit balance. It can only exist as account for as long as it has the companion asset account.

EXPENDITURES RELATED TO THE ACQUISITION AND USE OF OPERATIONAL ASSETS: CAPITAL EXPENDITURES Benefit current and future periods

REVENUE EXPENDITURES Benefit current period only

Journal entry on transaction date debits an asset account Incurred for the purchase or expansion of plant assets

Journal entry on transaction date debits an expense account Necessary to the ownership and use of plant and equipment

EXAMPLE Purchase of office computer Electricity consumed in using the computer Debit “Office Equipment” Debit “Utilities Expense”

Straight-line method (depreciation is the same for each year of the asset’s estimated useful life): Depreciation expense per year = (Original cost Salvage value) / Estimated useful life in years

MORE EXAMPLES: 1. Record the depreciation on December 31, 2018. Building purchased for P20M on June 1, 2018 with a useful life of 10 years.

*Depreciation expense under this method is measured solely by the passage of time. *Acquisition/Original cost - includes all expenditures necessary to obtain the asset and place it in its normal operating conditions *Estimated useful life - the expected life based on need for repair, service life, and vulnerability to obsolescence *Salvage/Residual/Scrap Value - estimate of the asset’s value at the end of its useful life

2. -

Example: Office equipment purchased on January 1, 2018, P30,000. Useful life = 5 years

Pro forma entry: Depreciation Expense Accumulated Depreciation

DEPRECIATION EXPENSE

xx xx

The company constructed its own building with the total cost amounting to P27,000,000. The building has an estimated useful life of 25 years and a salvage value of P2,000,000. The building was completed last May 31.

3.

Purchased equipment for P1,000,000 on January 31, 2018. Management assessed that the property can be sold at the end of its 7-year useful life for P123,456.78. Make the journal entry upon acquisition on January 31 and depreciation on December 31, 2018.

Methods of Accounting for Allowance for Doubtful Accounts A.

Direct write-off method Bad debts are not anticipated and no allowance account is used No entry is made for bad debts until an account is determined to be worthless or uncollectible; being doubtful not sufficient Accounts receivable is not recorded at NRV Not recommended because it violates the matching principle

Pro forma entry: Bad Debts Expense xx Accounts Receivable Example:

4.

Mr. Kaya Ko To purchased office equipment on October 1, 2015 for P48,000. He estimated that the equipment will have a P2,000 residual value at the end of its ten-year useful life. Using the straight line method of depreciation, what will be the balance of Accumulated Depreciation account on Dec. 31, 2017?

B.

5.

Record the depreciation on December 31, 2018. Land purchased for P10M on June 1, 2018 with a useful life of 10 years.

Allowance Method Estimate recorded when it is deemed to be material in amount Only doubtful Based on company’s past experience in collecting its customers’ outstanding accounts Adheres to matching principle

Pro forma entry: a. Doubtful Accounts Expense xx Allowance for Doubtful Accounts b. Allowance for Doubtful Accounts xx Accounts Receivable Example:

ACCOUNTS RECEIVABLE -

-

xx

Recorded in the statement of financial position (balance sheet) at its net realizable value Net realizable value (NRV) – amount expected to be received in cash excluding amounts that the company estimates will not be able to collect Net realizable value = Accounts receivable – Allowance for doubtful accounts

RECOVERY OF ACCOUNTS A.

Direct Write-off Method

Step 1: Accounts Receivable xx Bad Debts Expense xx (or Miscellaneous Expense)

xx xx

Step 2: Cash

xx Accounts Receivable

xx

Example: 3. Aging ◦ compute using aging schedule ◦ amount computed is the ending balance of allowance account. Apply the same concept as “increased to”

B.

Allowance Method EXERCISE 1 1. One-year rent paid in advance on March 31, 2018 amounting to 120,000. Record the adjusting entries on December 31, 2018.

Step 1: Accounts Receivable xx Allowance for Doubtful Accounts

xx A. Asset method

Step 2: Cash

xx Accounts Receivable

xx

Example:

B. Expense method

ASSUMPTIONS IN ALLOWANCE METHOD ▪ Only in allowance method, not in direct write-off method ▪ Not limited to percentage of receivables method ▪ If given a percentage, multiply it by the ending balance unless the contrary is given. 1. Increased by the same amount appears in the adjusting entry Example: Company estimates that doubtful accounts should be increased by 2,000

2. Increased to amount given is the ending balance (increased to). Solve for the adjustment. Example: company estimates that year-end doubtful accounts is 5,000. Assume beginning balance is 1,500.

2. Received cash for services not yet rendere...