Fundamentals of accounting (accounting equation and accounting process) PDF

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Receivable Financing (Pledging, Assignment and Factoring of Accounts Receivable)...

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Fundamentals of accounting Accounting is defined by ASC as “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 decision.”

Accounting equation: Assets = Liabilities + Owner’s equity

Assets = are defined as “resources controlled by the entity as a result of past transactions and events and from which future economic benefits are expected to flow to the entity”. Classifications: -current asset -non-current asset Liabilities = are defined as “present obligations of an entity arising from past transactions or events, the settlement of which is expected to result in an outflow from the entity of resources embodying economic benefits”. Classifications: -current liability -non-current liability Equity = is the residua interest in the assets of an entity after deducting all of its liabilities.

System of debits and credits: T-accounts= is the visual structure used in double entry bookkeeping to keep debits and credits separated

T-account ASSETS

LIABILITIES

WITHDRAWALS/DRAWINGS

EQUITY/OWNER’S EQUITY

EXPENSES

REVENUE AWE

LER

ACCOUNTING PROCESS = refers to the procedures or series of steps undertaken to come up with the information reported in the financial statements. = aka accounting cycle. = it is divided into two phases, namely: 1) recording phase and 2) summarizing phase.

Recording phase = includes collecting information about economic transaction and the recording of these transactions in the appropriate accounting records. Transaction= is an economic event that changes an asset, liability or an equity account balance; hence, it must be recorded. = is recorded in terms of debits and credits (double-entry system). Debit is the left side of an account while credit is the right side of an account. Accounting records= include business documents, journals and ledgers.

Accounting process steps: 1) Documentation 2) Journalizing -General journal -Special Journal

3) Posting -General ledger -Subsidiary ledger 4) Preparation of a Trial Balance 5) Compilation of data for adjustments 6) Preparation of worksheet 7) Preparation of financial statements -Statement of Financial Position (Balance Sheet) -Income Statement -Statement of Comprehensive Income -Statement of Cash Flows -Statement of Changes in Equity 8) Journalizing and posting of adjusting entries and closing entries 9) Preparation of Post-Closing Trial Balance 10) Preparation of Reversing Entries

The recording phase is composed of the following steps: 1) Documentation= process of preparing or receiving appropriate business documents. Business documents= are original source materials which serve evidence of transaction. Examples: a) Invoice= is issued when service or merchandise is given to a customer or client. b) Official Receipt= is issued when cash is received by the entity. c) Cash or check voucher= is a document used when cash is paid or a check is issued. d) Check= is a negotiable instrument used as a substitute for cash, the payment for which is drawn against the entity’s or individual’s current account. e) Statement of Account= is a bill presented to a customer for service rendered or merchandise given for which payment is demandable. f) Promissory note= is a written promise to pay a certain sum of money at a future date.

2) Journalizing= process of recording transactions for the first time in the books called journals. Books of original entry= another term of journals. General journal= most flexible type of journal where almost all types od=f transcations can be recorded. Special journal= are used in recording transactions that are usual and that occur frequently or on a repetitive basis. 3) Posting= process of transferring the recorded transactions in the journal to the accounts in the ledger. General ledger= is the principal ledger which contains all the accounts that are reported on the financial statements, namely: assets, liabilities, equity, income and expenses. = it also includes contra and adjunct accounts. Contra accounts= are accounts established to record deductions from related with positive balances such as Accumulated Depreciation (deducted from Property, Plant and Equipment), Discount on Notes Payable (deducted from Notes Payable), Sales Discount (deducted from Sales), and Purchase Discounts (deducted from Purchases). Adjunct accounts= are accounts set up to record additions to related accounts such as Freight-In (added to Purchases). Subsidiary ledgers= contain details of some general ledger account balances. Control account= it is a general ledger account that has a supporting subsidiary ledger.

Summarizing Phase = includes the steps necessary for the preparation of periodic summary reports. = it includes the following steps: 4) Preparing a trial balance= process of preparing a summary of the balances of the accounts in the general ledger known as a trial balance. = is normally done in a worksheet. Trial balance= is prepared to prove the equality of debits and credits but it does not indicate the accuracy of work done. 5) Compiling adjusting data= process of gathering and putting together various data necessary to update the balances of certain accounts in the books of the company.

Adjusting Entries = These are the entries needed to update these accounts to ensure their accuracy.

The following items are usually adjusted: a)

Accrued income

b)

Accrued expenses

c)

Deferred income

d)

Prepaid expenses

e)

Bad debts or doubtful accounts

f)

Depreciation

g)

Inventory

Cash Basis = Income is recognized only when cash is collected or expense is recognized only when cash is paid. Accrual Principle = Income is recognized as earned at the time service is rendered regardless of when cash is collected (this is also called the revenue recognition principle) and expense is recognized as incurred at the time service is received or used up regardless of when cash is paid (this is called the expense recognition principle). Expense recognition principle is also referred to as the matching principle because the expense (representing the effort of the business) should be matched against the income (representing the accomplishment of the business). The Generally Accepted Accounting Principle (GAAP) favors the accrual basis of fairly measuring income and expenses therefore adjustments should be made along this rule.

a) Accrued Income = this is the income earned but not yet received or collected as of the statement of financial position (balance sheet) date, such as accrued interest on notes receivable. = is not yet collected but is matched with expenses for the period. = the adjusting entry to record accrued income is as follows:

Dr. Receivable xxx Cr. Income

xxx

Example 1- A company received a 120-day, 12% note dated November 16, 2010 amounting to P300,000. Interest is receivable upon maturity of the note.

As of December 31, 2010, interest for 45 days (that is, November 16 to December 31) is already earned but not yet collected. The adjusting entry to record the accrual of interest is as follows: Dr. Interest Receivable 4,500 Cr. Interest Income

4,500

(P300,000 * 12% * 45/360= P4,500)

b) Accrued Expense = this is an expense incurred but not yet paid as of the statement of financial position (balance sheet) date, such as interest accrued on notes payable = is unpaid as of the statement of financial position date but is matched against income or earnings for the current period. = adjustment for accrued expense is recorded as follows: Dr. Expense xxx Cr. Payable

xxx

Example 2- The company has an outstanding 180-day, 12% note payable dated October 2, 2010 amounting to P200,000. The interest is payable upon maturity of the note. The company’s accounting period or financial year is the calendar year, that is January 1 to December 31. Interest for ninety days has accrued on the note as of December 31, 2010 (that is October 2 to December 31). The adjusting entry to record the accrued interest is as follows: Dr. Interest Expense Cr. Interest Payable

6,000 6,000

(P200,000 * 12% * 90/360= P6,000)

Example 3- A company pays salaries every Friday, the end of a five-day work week. The total salaries for the week ending January 3, 2011 is P180,000 In this case, the P180,000 salaries for the week ending January 3,2011 is for the services rendered by employees on December 30, December 31, January 1, January 2, and January 3. Therefore, the company has accrued salaries for two (2) days as of December 31, 2010. The adjusting entry to record the accrued salaries is as follows: Dr. Salary Expense 72,000 Cr. Salaries Payable

72,000

(P180,000 * 2/5= P72,000)

c) Unearned/Deferred Income = This is income already collected but not yet earned as of the statement of financial position (balance sheet) date, such as rental income collected in advance or subscriptions received in advance. = the receipt of the advance payment may be recorded using the liability method or the income method. Liability method= the collection is initially credited to a liability account; at the end of the accounting period, the earned portion of the income is transferred to an income account. Income method= the collection is initially credited to an income account; at the end of the accounting period, the unearned portion of the income is transferred to a liability account.

1) To record the initial receipt of cash Liability Method

Income Method

Dr. Cash

Dr. Cash

xxx

Cr. Unearned Income xxx

Cr. Income

xxx xxx

2) To record adjustment at the end of the accounting period Liability Method

Income Method

Dr. Unearned Income xxx

Dr. Income xxx

Cr. Income

Cr. Unearned Income xxx

xxx

(amount recorded is the earned

(amount recorded is the unearned

portion of the prepayment)

portion of the prepayment)

Example 4- On September 1, 2010, a company received P360,000 representing rental of an office space for one year beginning on this date. The entries to record the receipt of payment on September 1 and the adjusting entry on December 31 under the two methods are presented below:

Liability Method 2010 Sept. 1 Dr. Cash

360,000

Cr. Unearned Rent 360,000 Dec. 31 Dr. Unearned Rent 120,000 Cr. Rent Income

120,000

(P360,000 * 4/12= P120,000) The earned portion is the rent for the period September 1 to December 31 or four (4) months.

Income Method 2010 Sept. 1 Dr. Cash 360,000 Cr. Rent Income 360,000 Dec. 31 Dr. Rent Income 240,000 Cr. Unearned Rent

240,000

(P360,000 * 8/12= P240,000)

d) Prepaid Expenses = this is an expense paid or acquired in advance such as insurance premium. = other examples are rent paid in advance and office supplies purchased

= there are two methods of recording prepayments, namely: the asset method and the expense method. Asset method= the payment is initially debited to an asset account. At the end of the accounting period, the expired or used portion of the asset is transferred to an expense account. Expense method= the payment is initially debited to an expense account. At the end of the accounting period, the unexpired por unused portion of the asset is transferred to an asset account.

1) To record the initial payment of expense Asset Method

Expense Method

Dr. Prepaid Expense xxx

Dr. Expense xxx

Cr. Cash

xxx

Cr. Cash

xxx

2) To record adjustment at the end of the accounting period. Asset Method

Expense Method

Dr. Expense xxx

Dr. Prepaid Expense xxx

Cr. Prepaid Expense xxx

Cr. Expense

(amount recorded is the expired

(amount recorded is the unexpired

portion of the prepayment)

portion of the prepayment)

Example 5- On April 1, 2010, a company pad insurance premium of P60,000 covering a period of two years beginning on this date. The entries to record the payment on April 1 and the adjusting entry on December 31 under the two methods are presented below:

Asset Method 2010 Apr. 1 Dr. Prepaid Insurance 60,000 Cr. Cash

60,000

Dec. 31 Dr. Insurance Expense 22,500

Cr. Prepaid Insurance

22,500

(P60,000 * 9/24= P22,500) (The expired portion of the insurance premium is for the period April 1 to December 31, 2010 or a period of nine (9) months.)

Expense Method 2010 Apr. 1 Dr. Insurance Expense 60,000 Cr. Cash

60,000

Dec. 31 Dr. Prepaid Insurance 37,500 Cr. Insurance Expense

37,500

(P60,000 * 15/24= P37,500) (The unexpired portion of the insurance premium is 15 months; that is, 24 months less the expired portion of nine (9) months.)

e) Bad debts or doubtful accounts = these represent customers’ accounts that may no longer be collected or that may possibly become bad debts. = PAS No. 39 provides that trade accounts receivable should be reported in the statement of financial position at amortized cost. Amortized cost= is defined as the amount at which the receivable is measured at the time it was first recognized minus any payments and minus any reduction (directly or through the use of an allowance account) for uncollectibility. The entry to record estimated uncollectible accounts is as follows: Dr. Uncollectible Accounts Expense xxx Cr. Allowance for Uncollectible Accounts xxx PAS No. 39 require a careful assessment of the collectability of the receivables (classified as financial assets).

The amount of uncollectible accounts expense that will be reported in the income statement is computed as follows: Required allowance balance

Pxxx

Allowance balance before adjustment (+ debit balance/ - credit balance)

xxx

Uncollectible accounts expense for the period

Pxxx

The account “Allowance for Uncollectible Accounts” is a contra asset account; it is reported on the statement of financial position as a deduction from Accounts Receivable

Example 6- A company’s trial balance dated December 31, 2010, contains the following information: Accounts receivable

P 300,000 debit

Allowance for uncollectible accounts Sales

2,000 credit 1,500,000 credit

Estimated uncollectible accounts amounted to P6,000.

The entry to record uncollectible accounts expense follows: Dr. Uncollectible Accounts Expense 4,000 Cr. Allowance for Uncollectible Accounts 4,000

Required allowance balance Allowance balance before adjustment- credit Uncollectible accounts expense for the period

f) Depreciation

P6,000 2,000 P4,000

= is defined in PAS 16 as the systematic allocation of the depreciable amount of an item of property, plant and equipment over its useful life. Depreciable amount= is the cost of an asset, or other amounts substituted for cost, less its residual value. The entry to record depreciation expense is as follows: Dr. Depreciation Expense xxx Cr. Accumulated Depreciation xxx

Depreciation expense for the period is determined using any of the acceptable methods provided in PAS 16- straight-line method, diminishing balance method, and units of production method. Under the straight-line method, the annual depreciation expense is computed as follows: Depreciation expense/year= (Cost- Residual Value)/Estimated useful life (in year)

If the asset is used for less than a year, the proportionate expense should be calculated, unless the company adopts a different policy such as providing half year depreciation in the year of acquisition of the asset. The accounts “Accumulated Depreciation” is a contra asset account; it is reported in the statement of financial position as a deduction from the related property, plant and equipment account.

Example 7- A company acquired an office equipment on May 1, 2010 for P640,000. The asset has an estimated useful life of 5 years and an estimated residual value of P40,000. The entries to record depreciation expense in 210 and 2011 are as follows: 2010 Dec. 31 Dr. Depreciation Expense 80,000 Cr. Accumulated Depreciation 80,000 (P640,000 – P40,000)/5 years * 8/12) (Depreciation expense for 2010 is for eight months; that is, May 1 to December 31, 2010

2011

Dec. 31 Dr. Depreciation Expense 120,000 Cr. Accumulated Depreciation

120,000

(Depreciation expense for 2011 is for one year or twelve months)

g) Inventory = adjustment for inventory is necessary if the periodic inventory system is used. Periodic Inventory System= the company does not record the physical movement of goods. Purchase of goods are recorded in the nominal account “Purchases”. The reduction in inventory resulting from sale is not reflected in the books. Thus, the balance of the Inventory account shown in the company’s trial balance represents inventory at the beginning of the period. Because of this, adjusting entries are necessary to reflect the inventory at the end of the period. There are two methods of recording adjustments related to inventories. Under the first method, two entries are prepared: 1) to transfer the beginning inventory balance to the Income Summary account and 2) to establish ending inventory balance. The entry are as follows: 1) To transfer beginning inventory balance to Income Summary Dr. Income Summary xxx Cr. Inventory (or Merchandise Inventory) xxx 2) To record ending inventory balance Dr. Inventory (or Merchandise Inventory) xxx Cr. Income Summary

xxx

Under the second approach, a separate cost of goods sold account is set up and the entry to record the adjustment is as follows: Inventory (or Merchandise Inventory), end

xxx

Purchases Returns and Allowances

xxx

Purchases Discounts

xxx

Cost of Goods Sold

xxx

Inventory (or Merchandise Inventory), beg

xxx

Purchases

xxx

Freight-in

xxx

The balance of the Cost of Goods Sold account is closed to Income Summary as part of the normal closing entries.

6) Preparing a work sheet= this step is optional but it facilitates the preparation of the financial statements. Worksheet= is a working paper which contains the data in the trial balance: the adjustments compiled in step 5, and the developed income statement and statement of financial position data. 7) Preparing the financial statements= is done after the worksheet is completed = the data reported are taken from the completed work sheet. = however, if a worksheet is not prepared, the adjusting data must be journalized and posted before the financial statements can be prepared.

PAS 1 (revised 2010) provides that a complete set of financial statements shall consist of the following: 1) Statement of financial position (balance sheet) 2) Income statement 3) Statement of comprehensive income 4) Statement of cash flows 5) Statement of changes in owner’s equity 6) Notes

Under PAS 1 (revised 2010), a new basic statement is added – the statement of comprehensive income. This statement reports item of unrealized gains and losses that are not ...