Lesson 2:

Elements affecting the

Financial Statements
CMBE 2 | JOSE MARIA COLLEGE
 TOPICS

Accounting Assumptions

The Accounting Equation

Accounting for Business Transactions

The Five Major Accounts

 LEARNING OBJECTIVES

Explain the varied accounting concepts

01 and assumptions.

Illustrate the accounting equations and

perform operations involving simple cases
02 with the use of the accounting equation.

Describe the nature and analyze common

03 business transactions using the rules of debit
and credit.

Discuss the five major accounts that forms

04 up the financial statements.
REVIEW

In the previous lesson, we discussed the importance of financial

information to various user groups. Users must be confident that they can
rely on the financial information they are given when they are making
decisions. To increase users’ confidence, accounting practices need to
follow certain guidelines.

The rules that govern how accountants measure, process, and

communicate financial information are known as generally accepted
accounting principles, or GAAP.
REVIEW

Accounting principles draw their authority from their acceptance in the

business community. They are generally accepted by those people and
organizations who need guidelines in accounting for their financial
undertakings. (Lopez, 2016)
ACCOUNTING
ASSUMPTIONS
ACCOUNTING ASSUMPTIONS

Accounting assumptions or accounting postulates are the

basic notions or fundamental premises on which the
accounting process is based. Accounting assumptions serve as
the foundation in order to avoid misunderstanding but rather
enhance the understanding and usefulness of the financial
statements.

Financial statements are a key product of an accounting system

and provide information that helps people make informed
business decisions. Financial statements report on a business in
monetary terms. (Salosagcol, 2018)
ACCOUNTING ASSUMPTIONS

The Conceptual Framework for Financial Reporting mentions only one

assumption, namely going concern. However, implicit in accounting are
the basic assumptions of accounting entity, time period and monetary unit.
 ACCOUNTING ASSUMPTIONS

GOING CONCERN ASSUMPTION

The entity is assumed to carry on its operations for an indefinite period of time. Financial
statements are prepared normally on the assumption that the entity shall continue in
operation for the foreseeable future in the absence of evidence to the contrary.

ACCOUNTING ENTITY ASSUMPTION

The entity is treated separately from its owners. Only those transactions pertaining to the
entity are accounted for and included in the financial records. The personal assets,
obligations and transactions of owners are excluded.
 ACCOUNTING ASSUMPTIONS

TIME PERIOD ASSUMPTION

The entity’s indefinite life is divided into time periods or accounting period. An accounting
period is usually 12 months and may either be a calendar year or a fiscal year period.

A calendar year period begins from January 1 and end on December 31 of the same year. A
fiscal year period is also a 12-month period but begins on a date other than January 1 and
ends on the following year.

MONETARY UNIT ASSUMPTION

The assets, liabilities, equity, income and expenses are stated in terms of a common unit of
measure, which is peso in the Philippines. Also, the purchasing power of the peso is regarded
as stable or constant and that its instability is insignificant and therefore ignored.
THE ACCOUNTING
EQUATION
THE ACCOUNTING EQUATION

According to Ballada, 2014, financial statements tell us how a

business is performing and where it stands. They are the final
product of the accounting process.

But how do we arrive at the items and amounts that make up the
financial statements? The financial statements prepared by
accountant comprises five major accounts namely assets, liabilities,
owner’s equity, income and expense.

The most basic tool of the accountant is the accounting equation. It

measures the resources of a business and the claims to those
resources. The basic accounting equation can be shown as:

Assets = Liabilities + Owner’s Equity

 THE ACCOUNTING EQUATION

ASSETS
Assets are economic resources controlled by an entity that are expected to benefit the
business in the future. Cash, office supplies, merchandise inventory, furniture, land, and
buildings are examples of assets. Claims to those assets come from two sources.

LIABILITIES
Liabilities are debts that are payable to outsiders. These outside parties are called creditors.
For example, a creditor who has lent money to a business has a claim, a legal right, to a part of
the assets until the business pays the debt.
 THE ACCOUNTING EQUATION

OWNER’S EQUITY
Owner’s equity is the amount of an entity’s assets that remains after the liabilities are
subtracted. For this reason, owner’s equity is often referred to as net assets which can be
expressed as:

Owner’s Equity = Assets – Liabilities

 THE ACCOUNTING EQUATION

REVENUES OR INCOME
Revenues are "increases in economic benefits during the accounting period in the form of increases in assets or
decreases in liabilities that result in increases in equity, other than those relating to contributions from equity
participants".

The following points can be drawn from the definition of revenue:

1. Increase in benefits during the accounting period. Income is measured from period to period, and provides
economic benefits to the company.

2. Increase in assets or decrease in liabilities. The economic benefits mentioned above could be in the form of
an increase in assets or a decrease in liabilities. When a company renders services or sells goods, it receives
cash as payment; thereby increasing assets. It can also acquire a receivable if the sale was made on credit, or
receive any other asset in place of cash. Also, an existing liability may be forgiven or cancelled in exchange
for the company's services.

3. Increase in equity, other than contributions from equity participants. There are only two elements that
provide increases in equity: contributions from owners and revenues or income.
 THE ACCOUNTING EQUATION

EXPENSES
Technically, expenses are "decreases in economic benefits during the accounting period in the form of decreases in
assets or increases in liabilities that result in decreases in equity, other than those relating to distributions to equity
participants". From the long definition above, we can draw the following points:

1. Decrease in benefits during the accounting period - Expenses are measured from period to period, and
results in a decrease in economic benefits.

2. Decrease in assets or increase in liabilities - The decrease in economic benefits mentioned above could be
in the form of a decrease in assets or an increase in liabilities. When a company incurs an expense, it pays
cash; thereby decreasing assets. Besides cash, the company may also use other assets in paying expenses. It
may also incur in a liability in cases of accrued expenses (unpaid expenses).

3. Decrease in equity, other than distributions to equity participants - There are only two elements that
decrease equity: distributions to owners (i.e., withdrawals or dividends) and expenses.
THE ACCOUNTING EQUATION

The purpose of business is to increase owner’s equity through

revenues, which are amounts earned by delivering goods or services
to customers. Revenues increase owner’s equity because they
increase the business’s assets but not its liabilities.

As a result, the owner’s share of business assets increases. The

expanded accounting equation may be expressed as:

Assets = Liabilities + Owner’s Equity + Income - Expense

ACCOUNTING FOR
BUSINESS
TRANSACTIONS
ACCOUNTING FOR BUSINESS TRANSACTIONS

A business transaction is an economic event or condition that

directly changes an entity’s financial condition or directly affects its
results of operations.

An accounting transaction takes place when a business exchanges a

thing or things of value for another. All business transactions can be
stated in terms of changes in the three elements of the accounting
equation.

Debit Credit
Value/s received = Value/s given up

Note that for every value received,

there should also be another value given up.
ACCOUNTING FOR BUSINESS TRANSACTIONS

Scenario 1. Mrs. Cruz wants to put up her own sari-sari store, so she
used her savings amounting to ₱50,000 as her initial capital to put
up the sari-sari store.

In this scenario, we can observe that the ₱50,000 cash which was
invested in the sari-sari store is an actual resource supplied by Mrs.
Cruz, the owner.

Resources of the Business = Resources Supplied by Owner

Thus, we can say
Asset = Liabilities
Note that in this scenario, the entire resources were supplied by the
owner.
ACCOUNTING FOR BUSINESS TRANSACTIONS

Scenario 2. Mrs. Cruz started to operate her sari-sari store, she

bought supplies on account and promised to pay at the end of the
month. The supplies are worth ₱10,000.

In this scenario, we can observe that the business received resources

in the form of supplies worth ₱10,000. However, this was bought on
account, thus at the time of purchase, the ₱10,000 was not yet paid.

Resources of the Business = Resources Supplied by Owner

Thus, we can say
Asset = Liabilities
Note that in this scenario, the business obtained resources from
people other than its owner. The amount owed to these people is
called liability.
ACCOUNTING FOR BUSINESS TRANSACTIONS

Scenario 3. Mrs. Cruz wants to start her sari-sari store, so she used
her savings amounting to ₱50,000 as her capital but because the
amount was insufficient, the business borrowed additional cash from
a bank amounting to ₱10,000.

It can be observed that the business has a total cash resource

amounting to ₱60,000. But take note that the ₱60,000 is comprised
of ₱50,000 cash supplied by the owner and ₱10,000 cash supplied
by the bank.

Resources of the Business = Resources Supplied by Bank +

Resources Supplied by Owner
Thus, we can say
Asset = Liabilities + Owner’s Equity
ACCOUNTING FOR BUSINESS TRANSACTIONS

1. The two sides of the equation should always balance.

2. The effect of every transaction is an increase or a decrease in

one or more of the accounting equation elements.

3. The owner’s equity is increased by the amount invested by the

owner and decreased by withdrawals. In addition, the owner’s
equity is increased by revenues and decreased by expenses.
REVIEW QUESTIONS

1. What are the basic accounting assumptions?

2. Why should a business be regarded as a separate entity and

distinct from the owners?

3. What are the elements of financial statements?

4. What is the basic accounting equation?