Lesson 2

Elements affecting the Financial Statements

Topics:
 Accounting Assumptions
 The Accounting Equation
 Accounting for Business Transactions
 The Five Major Accounts

Learning Objectives:
 Explain the varied accounting concepts and assumptions.
 Illustrate the accounting equations and perform operations involving simple cases with
the use of the accounting equation.
 Describe the nature and analyze common business transactions using the rules of debit
and credit.
 Discuss the five major accounts that forms up the financial statements.

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.

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 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.

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.

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

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

Assets and Liabilities

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 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.

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
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.

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 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 - Expenses

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

Note that for every value received, there should also be another value given up.

There are three scenarios which can help us further understand the basic accounting situation.

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 = Owner’s Equity

Note that in this scenario, the entire resources were supplied by the owner.

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 Supplier

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.
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

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 increase by revenues and decrease 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?

Name: Score:
Block: Date:
Exercise 1. Using the concept of the accounting entity assumption, place “ √ ” if the event is
considered as a business transaction and “ x “ if not.
1. Salaries paid to employees.
2. Bought rice and fish for family consumption.
3. Repair of a car owned by business.
4. Salaries paid to house helpers.
5. Tuition fees for the children.
6. Incurred inventory loss due to theft and robbery.
7. Payment of household utilities.
8. Payment of personal accident insurance.
9. Repair of an old building used by the business.
10. Payment of hospitalization of parents.
11. Salary paid to family driver.
12. Cash withdrawn from the business.
13. The store building was razed by fire.
14. Payment made by owner of his personal loan to a bank.
15. Gasoline purchased for company car.
16. Repair of house owned by the manager.
17. Death of the business owner.
18. Supplies purchased for office works.
19. Salaries paid to contractual employees.
20. Sold goods to various customers.

Name: Score:
Block: Date:
Exercise 2. Multiple choice. Read and analyze each items carefully. Write the letter of your
which corresponds to your choice on the space before the number.

1. The primary motive of a person engaged in business

a. To render services to customers
b. To help the government in terms of taxes
c. To earn profit
d. For personal reasons

2. The basic accounting equation may be expressed as

a. Asset – Owner’s Equity = Liabilities
b. Assets – Liabilities = Owner’s Equity
c. Assets = Liabilities + Owner’s Equity
d. All of these

3. The monetary unit assumption

a. Applies only to corporate form of business organization.
b. Requires that all business transactions be measured in monetary terms.
c. Requires that all assets be initially recorded at cost.
d. Prevents entities from entering into non-monetary transactions.

4. These are resources controlled by the enterprise as a result of past transactions and events
and from which future economic benefits are expected to flow the enterprise
a. Assets
b. Liabilities
c. Owner’s Equity
d. Income
5. This element represents the claim of the of the creditor’s over the assets of the enterprise.
a. Income
b. Expenses
c. Liabilities
d. Owner’s Equity

6. What is the only underlying assumption mentioned in the Conceptual Framework for
Financial Reporting?
a. Going concern
b. Accounting Entity
c. Time Period
d. Monetary Unit

7. Which statement best describe the term going concern?

a. When current liabilities of an entity exceed current assets.
 b. The ability of the entity to continue in operation for the foreseeable future.
c. The potential to contribute to the flow of cash and cash equivalent to the entity.
d. The expenses exceed income.

8. The concept of accounting entity is applicable

a. Only to the legal aspects of business organizations
b. Only to economic aspects of business organizations
c. Only to business organizations
d. Whenever accounting is involved

9. Which underlying assumption serves as the basis for preparing financial statements at
regular arbitrary or artificial points in time?
a. Accounting entity
b. Going concern
c. Accounting period
d. Stable monetary unit

10. Which basic assumption may not be followed when an entity in bankruptcy reports
financial results
a. Economic entity assumption
b. Going concern assumption
c. Time period assumption
d. Monetary unit assumption

Name: Score:
Block: Date:
Exercise 3. Compute the missing amount and complete the accounting equation.

Assets Liabilities Owner's Equity

1. 48,000 32,000

2. 56,000 24,000

3. 70,000 30,000

4. 46,000 25,000

References: 5. 80,000 70,000

Ballada, S. 6. 40,000 20% and

Ballada,, W. (2014).
Accounting 7. 30,000 70%

8. 150,000 15%

9. 25,000 75%

10. 50% 15,000

Fundamentals. Manila: DomDane Publishers.

Lopez, R. M. Jr. (2016). Fundamentals of Accounting. Davao City: MS Lopez Printing and
Publishing.

Salosagcol, J (2018). Accounting. Manila: Re Leone Publishing.