FUNDAMENTALS OF

FINANCIAL ACCOUNTING
CHAPTER3
 LEARNING OBJECTIVES

1. Identify and explain the steps in the accounting process.

2. Prepare adjusting entries and understand the rationale for

their preparation.

3. Prepare closing entries and understand the rationale for

their preparation.

4. Explain the advantages of preparing reversing entries

and identify adjusting entries that may be reversed.
 ACCOUNTING PROCESS

Accounting process refers to the procedures or series of steps

undertaken to come up with the information reported in the
financial statements. The accounting process is also

referred to as the accounting cycle.

The accounting process is divided into two phases, namely:

(1) the recording phase and (2) the summarizing phase.
 RECORDING P.HASE

The recording phase includes collecting information about

economic transactions and the recording of such transactions in
the appropriate accounting records. A transaction is an economic
event that changes an asset, a liability, or an equity account
balance: hence, it must be recorded. Accounting records, on the
other hand, include business documents, journals, and ledgers.
Transactions are 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.
RULES OF DEBITS AND CREDITS
 1. DOCUMENTATION

this is the process of preparing or receiving appropriate

business documents. Business documents are original
source materials which serve as evidence of transactions.
They include official receipts; sale invoices, purchase

invoices, credit memoranda, and debit memoranda.

 2. JOURNALIZING

This is the process of recording transactions for the first time

in the books called journals. This is the reason why the
journals are called books of original entry
 3. POSTING

this is the process of transferring the recorded transactions in

the journal to the accounts in the ledger. A ledger is a group of
related accounts and is called the book of final entry. The
objective of posting is to classify the effects of transactions

on specific asset, liability, equity, income and expense

accounts.
 3. POSTING

The 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.
 3. POSTING

Contra accounts are accounts established to record deductions from related

accounts with positive balances such as Accumulated Depreciation
(deducted from Property, Plant and Equipment), Discount on Notes Payable
(deducted from Notes Payable), Sales Discounts (deducted from Sales), and
Purchases Discounts (deducted from Purchases).
 3. POSTING

Adjunct accounts are accounts set up to record additions to

related accounts such as Freight-In (added to Purchases).
 4. PREPARING A TRIAL BALANCE

this is the process of preparing a summary of the balances of

the accounts in the general ledger known as the trial balance.
After all transactions are posted, the balance of each account
is determined. Asset, expense and temporary capital account
such as Drawing have normal debit balances. Liability, equity,
and income or revenue accounts have normal credit balances
 5. COMPILING ADJUSTING DATA

this is the process of gathering and putting together various

data necessary to update the balances of certain accounts in
the books of the company. Adjustments based on compiled
data are then recorded before the financial statements are
prepared. These adjustments are necessary so that income

and expenses will be reported in the period they are 'earned

and incurred. respectively; hence, profit will not be misstated
 A. ACCRUED EXPENSE

this is an expense incurred but not yet paid as of the Statement of Financial
Position date, such as interest accrued on notes payable.
Another example is accrued salaries of employees. An accrued expense 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:

Expense XX
Payable XX
 EXAMPLE 1

The company has an outstanding 180-day, 12 note payable dated

October 2, 2018 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, 2008 (that is, October
2 to December 31). The adjusting entry to record the accrued interest is
as follows:
Interest Expense 6,000
Interest Payable 6,000
P200,000 x 12 x 90/360 =6,000
 B. ACCRUED REVENUE/INCOME-

this is a revenue or income earned but not yet received or collected

as of the Statement of financial Position date. such as accrued
interest on notes receivable. An accrued revenue or income is not
yet collected but is matched with expenses for the current period.
The adjusting

entry to record accrued revenue or income is as follows:

Receivable xxx

Revenue / Income xxx

 EXAMPLE 2

A company received a 120-day, 12% note dated November 16, 2018

amounting to P300,000. Interest is receivable upon maturity of the note.
As of December 31, 2018, 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 income is as follows:
Interest Receivable 4,500
Interest Income 4,500
P300,000 x 12 x 45/360 = P4,500
 C. PREPAID EXPENSE

- this is an expense paid or acquired in advance such as

insurance premium. Other examples are rent paid in advance

and office supplies purchased. The adjustment relating to
prepaid expense at the end of the accounting period
depends on the method used in recording the initial

payment.
 C. PREPAID EXPENSE

There are two methods of recording prepayments, namely: the asset method
and the expense method. Under the 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. Under the
expense method, the payment is initially debited to an expense account. At
the end of the accounting period, the unexpired or unused portion of the
asset is transferred to an asset account.
C. PREPAID EXPENSE
 EXAMPLE 3

On April 1, 2018, a company paid 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.
 ASSET METHOD

2018
Apr. 1
Prepaid Insurance 60,000
Cash 60,000
Dec. 31
Insurance Expense 22,500
Prepaid Insurance 22,500
P60,000 x 9/24 = P22,500
The expired portion of the insurance premium is for the period April 1 to
December 31, 2018, or a period of nine (9) months.
 EXPENSE METHOD

2018
Apr. 1
Insurance Expense 60,000
Cash 60,000
Dec. 31
Prepaid Insurance 37,500
Insurance Expense 37,500
P60,000 x 15/24 = P37,500
The unexpired portion of the insurance premium is 15 month, that is 24
months less the expired portion of nine (9) months.
 D. UNEARNED REVENUE/INCOME

this is a revenue or income already collected but

not yet earned as of the Statement of Financial Position date,
such as rental income collected in advance or subscriptions
received in advance. Unearned revenue or income is also
known as deferred revenue or income. Like prepaid expense,
the adjustment for unearned revenue or income at the end of
the accounting period depends on how the initial receipt of
cash is recorded.
 D. UNEARNED REVENUE/INCOME

The receipt of the advance payment may be recorded using the liability
method or the revenue or income method. Under the 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 or revenue account. Under the revenue or income method, the
collection is initially credited to a revenue or income account; at the end
of the accounting period, the unearned portion of the income is
transferred to a liability account
D. UNEARNED REVENUE/INCOME
 EXAMPLE 4

On September 1, 2018, a company received P 360,000

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.
 LIABILITY METHOD

2018
Sept. 1
Cash 360000
Unearned Rent 360,000
Dec. 31
Unearned Rent 120,000
Rent Income 120,000
P360,000 x 4/12 = P120,000
The earned portion is the rent for the period September 1 to December 31 or
four (4) months.
 REVENUE METHOD

2018
Sept. 1
Cash 360000
Rent Income 360,000
Dec. 31
Rent Income 240,000
Unearned Rent 240,000
P360,000 x 8/12 = P120,000
The earned portion is the rent for the period September 1 to December 31 or
four (4) months.
 E. DEPRECIATION

depreciation 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:

Depreciation Expense xxx

Accumulated Depreciation xxx
 E. DEPRECIATION

Depreciation expense/year = Cost less Residual Value

Estimated useful life (in years)

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.
 EXAMPLE 5

A company acquired an office equipment on May 1, 2008 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 2008
and 2019 are as follows:
2018
Dec. 31
Depreciation Expense 80,000
Accumulated Depreciation 80,000
(P640,000 - P40,000)/5 yrs. X 8/12
 EXAMPLE 5

A company acquired an office equipment on May 1, 2008 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 2008
and 2019 are as follows:
2019•
Dec. 31
Depreciation Expense 120,000
Accumulated Depreciation 120,000
(P640,000 - P40,000)/5 yrs.
Depreciation expense for 2009 is for one year or twelve (1 2) months.
 F. UNCOLLECTIBLE ACCOUNTS

these represent customers' account that may no longer be collected or that may
possibly become bad debts. PAS. 39 provides that trade accounts receivable should be
reported in the statement of Financial Position at amortized cost. Amortized costs 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:
Uncollectible Accounts Expense xxx
Allowance for Uncollectible Accounts xxx
.
 EXAMPLE 7

A company's trial balance dated December 31, 2008,

contains the following information:
Accounts receivable P 300,000 debit
Allowance for uncollectible accounts 2,000 credit
Sales 1,500,000 credit

Estimated uncollectible accounts amounted to P6,000.

 EXAMPLE 7

The entry to record uncollectible accounts expense follows

Uncollectible Accounts Expense 4,000
Allowance for Uncollectible Accounts 4,000
Required allowance balance P6,000
Allowance balance before adjustment - credit 2,000,
Uncollectible accounts expense for the period P4,000

.
 7. PREPARING THE FINANCIAL
STATEMENTS
after the work sheet is completed. the financial statements
are prepared. The data reported in the statements are taken
from the completed work sheet. However, if a work sheet is
not prepared, the adjusting data must be journalized and
posted before the financial statements can be prepared.
This is because the- data reported in the statements are
taken from the updated balances of the accounts in the
general ledger. The- financial statements are described as
the end product of the accounting process
8. ADJUSTING AND CLOSING THE BOOKS

the adjustments that were recorded in the work sheet are

now formally recorded in the general journal and posted to
the accounts in the general ledger. The balances of the
nominal (temporary) accounts. which consist of income,
expense, and drawing accounts, are then closed to Income
Summary account. The balance of the Income Summary
account is then Transferred to the owner's equity (capital)
account. A debit balance in the Income summary account
represents a loss while a credit balance represents a profit.
Lastly, the balance of the, owner's drawing account is closed
to owner's equity (capital) account. When the closing process
is completed, all nominal accounts will have zero balances.
8. ADJUSTING AND CLOSING THE BOOKS

Following are the pro-forma closing entries prepared at the

end of the accounting
period:
1. To close the balances of revenue or income accounts
Revenue / Income xxx
Income Summary xxx
2 .. To close the balance of expense accounts
Income Summary xxx
Expenses xxx
8. ADJUSTING AND CLOSING THE BOOKS

3. To close the balance of Income Summary account (credit

balance)
Income Summary xxx
Capital xxx
To close the balance of Income Summary account (debit
balance)
Capital xxx
Income Summary xxx
4. To close the balance of the drawing account
Capital xxx
Drawing xxx
 9. PREPARING A POST-CLOSING TRIAL
BALANCE
this step is done after all the balances of nominal accounts
have been closed; that is, their balances were reduced to
zero. Therefore, a post-closing trial balance contains only the
real accounts (assets. liabilities and equity); the balances of
these accounts are carried forward to the next accounting
period. A post-closing trial balance is prepared to check the
equality of debits and credits after journalizing and posting
the closing entries.
 10. REVERSING THE ACCOUNTS

certain adjusting entries recorded at the end of the

accounting period are reversed at the beginning of a new
accounting period. These adjustments include accrued
expenses, accrued revenues or income, prepaid expenses
recorded under the expense method and deferred revenues
or income recorded under the revenue method .
 10. REVERSING THE ACCOUNTS

1. Accrued expense
Payable xxx
Expense xxx
2. Accrued revenue/income
Revenue /Income xxx
Receivable xxx
3. Prepaid expense - expense method
Expense xxx
Prepaid Expense xxx
4. Deferred revenue or income - revenue method
Unearned Revenue/Income xxx
Revenue/Income xxx