Module 3: completing the accounting cycles of a service business

3.1 Worksheet and the Financial Statements

We have learned in the past module that the  worksheet is our basis for preparing the  financial
statements which includes:
 The Statement of Financial Position (Balance Sheet)
 The Statement of Financial Performance (Income Statement)
 The Statement of Changes in Equity and
 The Statement of Cash Flows
In this module, we will learn how to prepare the basic financial statements based on the worksheet that
we have already prepared.

3.1.1 The Work Sheet

The Worksheet
 A worksheet is a multiple-column form that may be used in the adjustment process and in
preparing financial statements.
 It is a working tool or a supplementary device for the accountant and not a permanent
accounting record.
 The use of a worksheet should make the preparation of adjusting entries and financial
statements easier.
1. Prepare trial balance on the worksheet
2. Enter Adjustment data
3. Enter adjusted balance
4. Extend adjusted balance to appropriate columns
5. Calculate income/loss and complete the worksheet

3.1.2 The Financial Statements

The Financial Statements
After transactions are identified, recorded, and summarized, four (4) Financial Statements are prepared
from the summarized accounting data:
 An Income Statement presents the revenues and expenses and resulting net income or net loss
of a company for a specific period of time.
 A Statement of Owner’s Equity summarizes the changes in owner’s equity for a specific period of
time.
 A Balance Sheet reports the assets, liabilities, and owner’s equity of a business enterprise at a
specific date.
 A Cash Flow Statement summarizes information concerning the cash inflows (receipts) and
outflows (payments) for a specific period of time.
 The Notes are an integral part of the financial statements.
3.2 Completing the Accounting Cycle
     After the financial statements had been generated, the remaining steps or procedures are to made to
complete the accounting cycle as follows:
 the closing entries
 the post-closing trial balance
which includes ruling the ledger to signify that the books of accounts for the period are closed.
To open the new accounting period, we have:
 opening entry
 reversing entry (optional)

3.2.1 The Closing Entries

Purpose of Closing Entries
Updates the owner’s capital account in the ledger by transferring net income (loss) and owner’s
drawings to the owner’s capital.
Prepares the temporary accounts (revenue, expense, drawings) for the next period’s postings
by reducing their balances to zero.
 
Temporary Versus Permanent Accounts
All revenue All asset account
All expense account all liability account
Owner’s drawing owner’s capital account
(income statement) (balance sheet)

3.2.2 The Post-Closing Trial Balance

The Post-Closing Trial Balance
 After all closing entries have been journalized and posted, a post-closing trial balance is
prepared.
 The purpose of this trial balance is to prove the equality of the permanent (balance sheet)
account balances that are carried forward into the next accounting period.
The post-closing trial balance is prepared from permanent account in the ledger.
The post-closing trial balance proves evidence that the journalizing and posting of closing entries has
been properly completed.

3.2.3 The Reversing Entries / Correcting Entries

The Reversing Entries (Optional Step)
 A reversing entry is made at the beginning of the next accounting period.
 A reversing entry reverses certain adjusting entries made in the previous period.
 Opening balances can then be ignored when preparing year-end adjusting entries.
 Eliminates monitoring balances of receivables and payables which were created by adjusting
entries
 Collections and payments in the succeeding period are done in the usual manner
 Optional Step: If the entity is using the Asset/Liability method in recording its transactions for:
1. cash payment for unutilized expenses (Prepaid Insurance)
2. cash received for un-rendered service (Unearned Income)
Applicable only: If the entity is using the Expense/Income method in recording its
transactions for:
 cash payment for unutilized expenses (Insurance Expense)
 cash received for unrendered service (Service income)
Correcting Entries
 Errors that occur in recording transactions should be corrected as soon as they are discovered
by preparing correcting entries.
 Correcting entries are unnecessary if the records are free of errors; they can be journalized and
posted whenever an error is discovered.
 They involve any combination of balance sheet and income statement accounts.

3.3 Summary: Completing the Accounting Cycle of a Service Business
 Closing entries - entries prepared after the financial statements are completed, this is to close all
nominal accounts preparatory to finally closing the book.
 The Income and Expense Summary account is used as a balancing account.
 Post-Closing Trial Balance
-the trial balance prepared after the closing entries.
-the trial balance of real accounts.
-this the basis of preparing the opening entries for the new accounting period.
 opening entry- entry in the general journal to open the new accounting period basis of which is
the post-closing trial balance.
 Reversing entries - reversals of adjusting entries  (optional)
Module 4: merchandising Business

4.1 Accounting for Merchandising

When you see a small sari-sari store, a grocery, a supermarket,  or a big department store such as SM or
Robinsons, regardless of the size or popularity, all of these establishments have one thing in common.
They are all classified as a merchandising business.
What is a merchandising business?
 A merchandising business is an enterprise that buys and sells goods to earn a profit such as:
1. Wholesalers sell to retailers. 
2. Retailers sell to consumers.

4.1.3 Source Documents

Merchandising businesses use various forms and documents to help identify the transactions
that should be recorded in the books.
These are source documents that contain vital information about the nature and amount of the
transactions. They are also called "business documents".
 Sales Invoice-
 Bill of lading-
 Statement of Account-
 Official Receipt-
 Deposit slips-
 Checks-
 Purchase requisition-
 Receiving Report-
 Credit Memorandum-
4.1.4 Terms of Transactions
 Cash or COD (Cash on Delivery)
purchase of merchandise is payable in cash
 On Credit or on Account
purchase of merchandise is payable in some future time
 Credit Term or Credit Period
the time within which the payment should be made
n/30 -payable within  30 days from the date of invoice
n/EOM - payable at the end of the month
10 EOM- payable up to 10 days after the end of the month
 
 Quantity Discounts
Volume purchase or sale terms may permit the buyer or seller to claim a volume or quantity
discount called trade discounts.
The discounted amount is the invoice price.
 catalog or list price  less the trade discount  = invoice price
 Catalog price  = P 1,500 , trade discount = 10%
 Invoice Price = P 1,500 x 90% = P 1,350
 
Purchase Discounts
Credit terms may permit the buyer to claim a cash discount for the prompt payment of a
balance due.
The buyer calls this discount a purchase discount.
 a contra-purchases account has a normal credit balance.
A purchase discount is based on the invoice cost less any returns and allowances granted.
example : 5/10,  2/15, n/30
                 5% discount if paid within 10 days from date of invoice
                  2% discount if paid within 15 days from date of invoice
                  payable within 30 days, no discount.
illustration: Mr.  A purchased school supplies for his business with Invoice Price of P1,350 on
June 1. Credit terms: 5/10, 2/15, n/30. Mr. A paid on June 12. What is the amount of discount?
        Analysis: From June 12 to June 1 = 11 days beyond 10 days
                             applicable discount = 2% x P 1,350 = P 27
 
Sales Discounts
A sales discount is the offer of a cash discount to a customer in exchange for the prompt
payment of a balance due.
Similar to Sales Returns and Allowances, Sales Discounts is also a contra revenue account with a
normal debit balance.
 
Freight Costs
The sales agreement should indicate whether the seller or the buyer is to pay the cost of
transporting the goods to the buyer’s place of business.
 FOB Shipping Point
Goods delivered to shipping point by seller
Buyer pays freight costs from shipping point to destination
 FOB Destination
Goods delivered to destination by seller
Seller pays freight costs
 
Accounting for Freight Costs
 Freight In is debited by the buyer if the buyer pays the freight bill (FOB shipping point).
 Freight Out is debited by the seller if the seller pays the freight bill (FOB destination).
 Freight Prepaid - seller pays for freight from shipping point
 Freight collect - buyer pays for freight when delivered to destination
4.1.5 Inventory Systems
Inventory Systems (used in Merchandising)
1. Perpetual Inventory System   4.1.5.1 Perpetual Inventory System
where detailed records of each inventory purchase and sale are maintained.
The cost of goods sold is calculated at the time of each sale.
Updates inventory and cost of goods sold after every purchase and sales transaction
Makes use of the “stock card”
2. Periodic Inventory System    4.1.5.2 Periodic Inventory System
detailed records are not maintained.
The cost of goods sold is calculated only at the end of the accounting period.
Delays updating of inventory and cost of goods sold until end of the period
Misstates inventory during the period
 
Determining Inventory Quantities
In order to prepare financial statements, it is necessary to determine the number of units of
inventory owned by the company at the statement date and to value them.
The determination of inventory quantities involves
taking a physical inventory of goods on hand, and
determining the ownership of goods.
Taking a physical inventory involves counting, weighing, or measuring each kind of inventory on
hand.
 
Terms of the Sale
Ownership of Consigned goods
 Under a consignment arrangement, the holder of the goods (called the consignee) does
not own the goods.
 Ownership remains with the shipper of the goods (consignor) until the goods are
actually sold to a customer.
 Consigned goods should be included in the consignor’s inventory, not the consignee’s
inventory.
 
Inventory Methods
1. The Specific Identification method
Each item of inventory is marked, tagged, or coded with its specific unit cost.
It is most frequently used when the company sells a limited variety of high unit-cost items.
2. The FIFO method
Under FIFO, the costs of the earliest goods purchased are the first to be recognized as cost of
goods sold.
The costs of the most recent goods purchased are recognized as the ending inventory.
3. The Average Cost method
assumes that the goods available for sale are homogeneous.
The allocation of the cost of goods available for sale is made on the basis of the weighted
average unit cost incurred.
The weighted average unit cost is then applied to the units sold to determine the cost of goods
sold and to the units on hand to determine the ending inventory.
Income Statement Effects
In periods of rising prices, FIFO reports the highest net income, 
The reverse is true when prices are falling.
When prices are constant, all cost flow methods will yield the same results.
Balance Sheet Effects
 FIFO produces the best balance sheet valuation since the inventory costs are closer to their
current, or replacement, costs.
 
The Formula for Cost of Goods Sold
Cost of Goods
Beginning  Inventory + - Ending Inventory = Cost of Goods Sold
Purchased

Ending Inventory Error  Balance Sheet Effect

The effect of ending inventory errors on the balance sheet can be determined by using the basic
accounting equation:
Assets = Liabilities + Owner’s Equity
Valuing Inventory at the Lower of Cost and Market
When the value of inventory is lower than the cost, the inventory is written down to its market
value.
This is known as the lower of Cost and Market (LCM) method.
The market is defined as Replacement Cost or Net Realizable Value (NRV).
4.1.6 Value -Added Tax Entries
Business Taxes for Merchandising
A. Value Added Tax
 is expressed as a percentage of the sales price or purchase price on selected goods sold
or purchased.
 It is the 12% Input tax for Purchases and Output tax for Sales if any.
 These two taxes are closed every month and the difference may present a:
 tax payable if the Output tax > Input tax
 deferred tax asset if the Output tax < Input tax
 Applicable for businesses with annual gross receipts of P 3M or more.
 
How to compute for  Vat

If the price of the Goods is exclusive of Vat

 Vat = Price of the Goods X 12%
 Vat= P10,000 x 12% = P 1,200

If the price of the Goods is inclusive of Vat

       Vat = Price of the goods / 112%  X 12%
       Vat = P 10,000 / 112% x 12% = P 1,071.43
B. Percentage Tax
 is expressed as a percentage of the gross sales per month.
 The 3% Sales tax is applicable for businesses with annual gross receipts of less than P
3M.
 Exempted from business taxes are businesses whose annual gross receipts does not
exceed P 1.5 M
 
Sales Taxes on Revenues
The retailer collects the tax from the customer when the sale occurs and remits the collections
to the BIR.
Sales taxes are not revenue but are a current liability until remitted.
4.2 The Income Statement of a Merchandising Business
Net Sales
the first part of the merchandising income statement.
Under accrual accounting, the Gross Sales is consist of cash and on a credit account.
Sales Discounts are discounts that have accumulated for the period. It is a contra-income
account and id deducted from gross sales.
Sales Returns are for goods that are damaged or defective returned by the buyer and refunded
in cash while Allowances are deducted from the selling price evidenced by a Credit Memo.
 
Cost of Sales or Cost of Goods Sold
 is the largest single expense of the merchandising business.
 It is the cost of inventory that was sold to the customers.
 the Goods Available for Sale for the year is the sum of 2 Factors, the Merchandise
Inventory at the beg. of the year and the Net Cost of Goods Purchased.
 the Merchandise Inventory, end is the goods unsold for the year. It is usually arrived at
through the use of the “stock cards or through “physical counting” at the end of the
year.
Operating Expenses
It is the 3rd major part of the income statement of a merchandising entity. These are expenses,
other than the Cost of Sales, which are incurred to generate profit from the entity’s major line
of business.
It is classified into 3 categories:
 distribution or selling expenses
 administrative expenses
 other operating expenses
 Selling expenses are those expenses directly related to the entity’s efforts to generate
sales. These includes:

 sales, salaries, and commissions

 related payroll employer expenses,
 traveling expenses
 advertising and store displays
 store supplies used
 depreciation of store property and equipment
 transportation-out or freight-out
Administrative expenses are those expenses related to the general administration of
the business. These includes:
 officers and office salaries
  related employer payroll expenses
 office supplies used
 depreciation of office property and equipment
 business taxes
 professional services
 uncollectible accounts expense
 general office expenses
Other operating expenses are those expenses that are not related to the central
operations of the business. These includes:
 loss on sale of investments
 loss on sale of property and equipment
 business taxes
 professional services
 uncollectible accounts expense
 general office expenses
 
Analysis of Expenses
According to PAS 1, the entity should present an analysis of expenses using a classification
based on either the nature of expenses or their function within the entity to provide
information that is reliable and more relevant
Nature of expense method, expenses are combined according to their nature and not according
to their function.
Ex. Depreciation expense, amortization cost, transportation cost, advertising cost, etc.
The function of expense method, or the “Cost of sales method” classifies expenses according to
their function as either part of:
Cost of sales
Distribution or selling expense
Administrative expenses
Other operating expenses
4.3 Summary : Merchandising Business
a business engaged in the buying and selling of goods.
differs from a Service business in the preparation of the income statement because of these
two (2) sections: Sales and Cost of sales.
 Purchases -account used to record the acquisition of goods.
 Sales - account used to record the revenue from goods sold.
 Purchase returns and allowances - account used for goods returned to the seller; contra-
purchase account.
 Sales returns and allowances - accounts used for goods returned by the buyer; contra-
sales account.
 Merchandise Inventory- stock of goods held for sale.
 Inventory Systems to record and determine Inventory:
 Perpetual Inventory System - up to date record; maintains a stock card.
 Periodic Inventory System- requires physical counting of inventory.
Inventory Costing  Methods:
-First-In, First-Out
-Specific Identification
-Average method
 Trade discounts-discounts for volume purchases.
 Cash discounts - discount for early payment.
 Freight - in - transportation cost shouldered by the buyer, part of the cost of purchases.
 Freight -out -cost shouldered by the seller, part of selling expenses.
Value Added Tax - a tax levied by the government to certain providers of goods and
services passed on to the customers and to be later remitted to BIR.
 Input Vat - Vat paid for purchases.
 Output  Vat - Vat received from sales.
Income Statement can be presented in two formats:
 by nature
 by function