Module 2: The Accounting Equation Lesson 1; Analyzing Business Transactions Lesson 2: Effect of Transactions in the Accounting Equation Lesson 3: Expanding the Accounting Equation Lesson 4: Typical Account Titles Used Lesson 5: The Basic Financial Statements Introduction ACCOUNTING EQUATION is a mathematical expression used to describe the relationship between the assets, liabilities and owner’s equity of the business model. The basic accounting equation states that assets equal liabilities and owner’s equity, but can be modified by operations applied to both sides of the equation, e.g., assets minus liabilities equal owner’s equity. ASSETS = LIABILITIES + OWNER'S EQUITY Assets are a company’s resources—things the company owns. Examples of assets include cash, accounts receivable, inventory, prepaid insurance, investments, land, buildings, equipment, and patents. Liabilities are a company's obligations—amounts the company owes. Examples of liabilities include notes or loans payable, accounts payable, salaries and wages payable, interest payable, and income taxes payable. Owner's Equity or stockholders’ equity is the amount left over after liabilities are deducted from assets. If a company keeps accurate records, the accounting equation will always be ‘in balance,” meaning the left side should always equal the right side. The balance is maintained because every business transaction affects at least two of a company's accounts. For example, when a company borrows money from a bank, the company’s assets will increase and its liabilities will increase by the same amount. When a company purchases inventory for cash, one asset will increase and one asset will decrease. Because there are two or more accounts affected by every transaction, the accounting system is referred to as double-entry accounting. Learning Objectives At the end of the module, the student shall be able to: 1. Determine if a business transaction is measurable or not. 2. Recognize the effects of a transaction to the accounting equation. B3. Identify and enumerate the different factors affecting the expanded accounting equation. 4. |dentify and enumerate the different account title used. 5. Prepare financial statements. Lesson 1 - ANALYZING BUSINESS TRANSACTIONS A business transaction is an economic event that has a direct impact on the business. A business transaction almost always requires an exchange between the business and another outside entity. We must be able to measure this exchange in terms of money (Philippine Peso). All business transactions affect the accounting equation through specific accounts. An account is a separate record used to summarize changes in each asset, liability, and owner’s equity of a business. Account titles provide a description of the particular type of asset, liability, or owner’s equity affected by a transaction. Three basic questions must be answered when analyzing the effects of a business transaction on the accounting equation. 1, What happened? + Make certain you understand the event that has taken place. 2. Which accounts are affected? + Identify the accounts that are affected. + Classify these accounts as assets, liabilities, or owner’s equity. 3. How is the accounting equation affected? + Determine which accounts have increased or decreased. + Make certain that the accounting equation remains in balance after the transaction has been entered. Lesson 2 - EFFECT OF TRANSACTIONS ON THE ACCOUNTING EQUATION Each transaction affects at least two accounts and one or more of the three basic accounting elements. A transaction increases or decreases specific asset, liability, or owner’s equity accounts. Sole Proprietorship Transaction #1. Let’s assume that RZ Torres forms a sole proprietorship called Accounting Software Co. (ASC). On December 1, 20XX, RZ Torres invests personal funds in the form of a cash amounting to Php1,000,000 to start ASC. The effect of this transaction on ASC’s accounting equation is: Assets = Liabilities + Owner’s Equity Cash + Torres, Capital Dec. 1 + Php 1,000,000 No effect + +Php 1,000,000 14Analysis: This means that the business has an asset in cash amounting to Php1,000,000 and that RZ Torres has a right over this. Sole Proprietorship Transaction #2. On December 3, 2013 Accounting Software Co. spends Php35,000 of cash to purchase computer equipment for use in the business. The effect of this transaction on the accounting equation is: Assets = Liabilities + Owner's Equity Cash Equipment Torres, Capital Dec.1 _Php 1,000,000 + Php 1,000,000 3 -35,000 35,000 Bal Php965,000 35,000 = Php1,000,000 Analysis: The accounting equation reflects that one asset increases and another asset decreases. Since the amount of the increase is the same as the amount of the decrease, the accounting equation remains in balance. Sole Proprietorship Transaction #3. On December 4, 2013 ASC obtains Php 300,000 by borrowing money from a bank. The effect of this transaction on the accounting equation is: Assets = Liabilities + Owner’s Equity Cash Equipment = Loan + Torres, Capital Payable Dec. 1 _Php 1,000,000 = + __ Php 1,000,000 3 35,000 35,000 Bal Php965,000 35,000 = Php1,000,000 4 +300,000 =__¥300,000 Bal Php 1,265,000 35,000 = 300,000 + 7,000,000 Analysis: ASC’s assets increase and ASC's liabilities increase by Php 300,000. Lesson 3 - EXPANDING THE ACCOUNTING EQUATION: REVENUES, EXPENSES AND WITHDRAWALS, Three key accounting elements of every business entity were defined and explained: assets, liabilities, and owner’s equity. To complete the explanation of the accounting process, three additional elements must be added to the discussion: revenues, expenses, and withdrawals. 45The EXPANDED ACCOUNTING EQUATION ASSE = LIABILITIES + PIC + REgeg + R—E Legend: PIC = Paid-in Capital RE beg - Retained Earnings E = Expenses FACTORS AFFECTING THE OWNER’S EQUITY ACCOUNT The principal causes of its increases and decreases are the following: Investment of the owner. Additional investments of the owner. Withdrawals of the owner. Revenues Expenses yaeene REVENUES - SFAS No.1 define revenues as gross increases in assets or gross decreases in liabilities recognized and measured in conformity with the GAAP that result from those type of profit-directed activities of an enterprise that can change owner's equity. Kinds: 1. Service Revenues - revenues earned by performing services for a customer or client. 2. Sales Revenues - revenues earned as a result of sale of merchandise. EXPENSES - SFAS No.1 defines expenses as gross decreases in assets or gross increases liabilities recognized and measured in conformity with the GAAP that result from those types of profit-directed activities of an enterprise that can change the owner’s equity. WITHDRAWALS - Withdrawals, or drawing, reduce owner’s equity as a result of the owner taking cash or other assets out of the business for personal use. Sole Proprietorship Transaction #4. On December 5, 2013 Accounting Software Co. pays Php 25,600 for ads that were run in recent days. The effect of this advertising transaction on the accounting equation is: 16Assets = Liabilities + Owner's Equity Cash Equipment = = —_Loan + Torres, Capital Payable Dec. 1 + Php 1,000,000 = + _+ Php 1,000,000 3 =35,000 35,000 Bal Php965,000 35,000 = Php1,000,000 4 +300,000 = +300,000 Bal Php 1,265,000 35,000 = 300,000 + 1,000,000 5 25,600 = = 25,600 Bal 7,239,400 35,000 = 300,000 + 974,400 Analysis: Since ASC is paying Php 25,600, its assets decrease. The second effect is a Php 25,600 decrease in owner's equity, because the transaction involves an expense. (An expense is a cost that is used up or its future economic value cannot be measured.) Sole Proprietorship Transaction #5. On December 6, 2013 ASC performs consulting services for its clients. The clients are billed for the agreed upon amount of Php 40,000. The amounts are due in 30 days. The effect on the accounting equation is: Assets = Liabilities + Owner’s Equity Cash Account Equipment = Loan + Torres, Capital Receivable Payable Dec. 1 + Php 1,000,000 : ++ Php 1,000,000 3 =35,000 35,000 Bal Php965,000 35,000 = Php1,000,000 4 +300,000 = __#300,000 Bal Php 35,000 = 300,000 + 7,000,000 1,265,000 5 =25, 600 = = 25,600 Bal 1,239,400 35,000 = ~+300,000~=* 974,400 6 +40,000 + 40,000 Bal 1,239,400 40,000 35,000 300,000 1,014,400 Analysis: Since ASC has performed the services, it has earned revenues and it has the right to receive Php 40,000 from the clients. This right (known as an account receivable) causes assets to increase. The earning of revenues causes owner's equity to increase. Sole Proprietorship Transaction #6. On December 8, 2013, RZ Torres withdraws Php100,000 of cash from the business for his personal use. The effect of this transaction on ASC’s accounting equation 7Dec. 1 Assets Liabilities + Owner's Equity cash Account Equipment Loan Payable + Ott, Capital tt, Drawings Receivable + Php 1,000,000 ++ Php 1,000,000 3 35,000 35,000 Bal PPIs, 000 35,000 PRPT, 000,000 4 $300,000 = 330,000 Bal Php 1,265,000 35,000 300,000 + 7,000,000 5 75,600 = 15,500 Bal T259,A00 35,000 300,000 + 974400 ‘ 000 + 0,000 Bal T2540 40,000 35,000 = 300000 + Tora 07 “700,000 700,000 al 739,400 35,000 300,000 + Tora 07 700,000 TE WALRCY TRALEE) Analysis: The accounting equation remains in balance since ASC’s assets have been reduced by Php 100,000 and so is the owner's equity under a new account title, Ott, drawings. Lesson 4 - Typical Account Titles Used Assets - are commonly subdivided into two major classifications: current assets and non-current assets. Current Assets - are generally those which can be expected to provide benefits to the business within the normal operating cycle of the business or one year, whichever is longer. = Cash. Any medium of exchange that a bank will accept at face value. It includes coins, currency, checks, money orders, bank deposits and drafts. - Cash Equivalent. These are short-term, highly liquid investments which are readily convertible to cash and with original maturities of three months or less. - Short-term Investments. Investments which are readily marketable and represent temporary investments of funds available for current operations and are intended to meet with working capital requirements. - _ Notes Receivable. A written pledge that the customer will pay the business a fixed amount of money on a certain date. : Accounts Receivable. Claims against customers arising from sale of services or goods on credit. This type of receivable offers less security than a promissory note. - Inventory. items of tangible personal property which are (a) held for sale in the ordinary course of business, (b) in the process of production for such sale, or (c) to be currently consumed in the production of goods and services to be available for sale. 18- Prepaid Expenses. Expenses paid for by the business in advance. It is an asset because the business avoids having to pay cash in the future for a specific expense. These include insurance and rent. Non-current assets - are those which are used to provide the business entity with benefits over a number of years. - Long-term Investments, Assets not directly identified with the operating activities of the company or involved in the sale or production of goods and services. Long-term investments are those usually acquired for regular income, control, meeting business requirements, value appreciation and protection. - Land. Owned and used by the business entity. No depreciation is recorded. - Equipment. Records the acquisition and disposition of office machines, desks, cars, trucks, file cabinets, and similar items. These assets have an estimated useful life beyond one year and are subject to depreciation. - Buildings. Included in this account are factories, warehouses, and office buildings. These are also subject to depreciation over a number of years. - Accumulated Depreciation. It is a contra account that contains the sum of the periodic depreciation charges. The balance of this account is deducted from the cost of the related asset - equipment or building - to obtain book value. - Intangibles. Long-lived assets without physical characteristics which value lies in rights, privileges and competitive advantages, which they give the owner. These include patents, copyrights, licenses, franchises, trademarks, etc. Liabilities - They typically fall into two major groups: Current and long term liabilities. Current Liabilities - are obligations which are reasonably expected to be settled through the use of existing current assets or the creation of other current liabilities within the normal operating cycle or one year, whichever is longer. - Notes Payable. It is like a note receivable but in reverse sense. The business entity is the maker of the note that is the business entity is the party who promises to pay the other party a specified amount of money on a specified future date. - | Accounts Payable. This account represents the reverse relationship of the accounts receivable. BY accepting the goods or services, the buyer agrees to pay for them in the near future. - Accrued Liabilities. Amounts owed to others for unpaid expenses. This account includes salaries payable, utilities payable, interest payable and taxes payable. - _Unearned Revenues. When the business entity receives payment before providing its customers with goods and services, the amounts received are recorded in 19the unearned revenue account (liability method). When the goods or services are provided to the customer, the unearned revenue is reduced and revenue is recognized. Long-term Liabilities - obligations which are payable beyond the operating cycle or one year, whichever is longer, or those obligations which though payable within one year will not be liquidated by existing current assets. - Mortgage Payable. This account records long-term debt of the business entity for which the business has pledged certain assets as security to the creditor. - Bonds Payable. Business organizations often obtain substantial sums of money from lenders to finance the acquisition of equipment and other needed assets. They obtain these funds by issuing bonds. The bond is a contract between the issuer and the lender specifying the terms of repayment and the interest to be charged. Owner’s Equity - Capital. This account is used to record the original and additional investments of the owner of the business entity. It is increased by the amount of net income earned during the year or is decreased by a net loss. This account title bears the name of the owner. - Withdrawals. When the owner of a business entity withdraws cash or other assets, such are recorded in the drawing or withdrawal account rather than directly reducing the owner’s equity account. - Income Summary. It is a temporary account used at the end of the accounting period to close revenues and expenses. This account shows the net income or net loss for the period before closing to the capital account. Lesson 5 - The Basic Financial Statements Financial Statements represent a formal record of the financial activities of an entity. These are written reports that quantify the financial strength, performance and liquidity of a company. Financial Statements reflect the financial effects of business transactions and events on the entity. Four Types of Financial Statements The four main types of financial statements are: 1, Statement of Financial Position Statement of Financial Position, also known as the Balance Sheet, presents the financial position of an entity at a given date. It is comprised of the following three elements: Assets: Something a business owns or controls (e.g. cash, inventory, plant and machinery, etc) 20© Liabilities: Something a business owes to someone (e.g. creditors, bank loans, etc) ‘© Equity: What the business owes to its owners. This represents the amount of capital that remains in the business after its assets are used to pay off its outstanding liabilities. Equity therefore represents the difference between the assets and liabilities. 2. Income Statement Income Statement, also known as the Profit and Loss Statement, reports the company's financial performance in terms of net profit or loss over a specified period. Income Statement is composed of the following two elemen © Income: What the business has earned over a period (e.g. sales revenue, dividend income, etc) Expense: The cost incurred by the business over a period (e.g. salaries and wages, depreciation, rental charges, etc) 3. Statement of Changes in Equity Statement of Changes in Equity, also known as the Statement of Retained Earnings or Capital Statement, details the movement in owners’ equity over a period. The movement in owners’ equity is derived from the following components: ©. Net Profit or loss during the period as reported in the income statement © Share capital issued or repaid during the period © Dividend payments ° Gains or losses recognized directly in equity (e.g. revaluation surpluses) Effects of a change in accounting policy or correction of accounting error 4, Cash Flow Statement Presents the movement in cash and bank balances over a period. The movement in cash flows is classified into the following segments: © Operating Activities: Represents the cash flow from primary activities of a business (Revenues and expense). Investing Activities: Represents cash flow from the purchase and sale of assets other than inventories (e.g. purchase of a factory plant) © Financing Activities: Represents cash flow generated or spent on raising and repaying share capital and debt together with the payments of interest and dividends. Cash Flow from Operating Activities present the cash generated (or used) in the ordinary activities of an entity, such as selling cars for a car dealer. The following are the major classes of operating cash flows: Cash Inflows o Receipts from sale of goods and performance of services o Receipts from interest on receivables. ©. Sales of trading securities 21Cash Outflows © Payments to suppliers © Payments to employees Payments for taxes Payments for interest expense (short-term) Payments for other operating expenses Payments of Trading securities o0° Cash Flow from Investing Activities report the cash used by a company in the investment of assets other than those which a company normally trades in (e.g. purchase plant and machinery in the case of a manufacturing business). It also includes cash inflow from the sale of such assets. Cash Inflows o Receipts from sale of property or equipment o Receipts from sale of investments in debt or equity securities o Receipts from collections on loans Cash outflows co Payments to acquire property and equipment © Payments to acquire debt or equity securities © Payments to make loans to others generally in the form of notes receivable Cash Flow from Financing Activities present the cash flow raised by acquiring finance such as by issuing shares or debentures, It also includes the related costs of finance (i.e. payment of dividends and interest). Conversely, this section includes cash spent in the repayment of share capital and debt. Cash Inflows o Receipts from investments by owners o Receipts from issuance of notes payable Cash outflows © Payments to owners in the form of withdrawals Payments to settle notes payable RELATIONSHIP AMONG THE FINANCIAL STATEMENTS 1, The income statement reports all revenues and expenses during the period. The results of operations- net income or net loss is the final figure in this statement. 2, The statement of changes in owner’s equity or capital statement considers the net income or net loss figure from the income statement as one of the determining factors that explains the change in owner’s equity. 3. The balance sheet reports the ending owner’s equity, taken directly from the capital statement. 4, The statement of cash flows reports the net increase or decrease in cash during the period and ends with the cash balance reported in the balance sheet. This statement is prepared based on the information from the income statement and the balance sheet 22ILLUSTRATIVE EXAMPLI Joe Rosario is a painting contractor. He owned the JR Paints and Designs. During the month of November, he completed the following transactions: Nov.3 4 5 6 7 10 1 2 B 14 18 20 21 24 7 28 30 Invested in the business painting equipment valued Php 24,700 and Php 150,000 cash. Acquired a service vehicle costing Php 80,000. Paid Php 30,000 as downpayment and signed a note for the balance Purchased painting supplies on account for Php 4,300 Completed a painting job and billed the customer Php 4,800 Received Php 1,500 cash for painting an apartment room Purchased painting supplies for Php 1,600 cash. Received Php 4,800 from the customer billed November 6. Billed a customer Php 6,200 for a painting job. Paid his assistant Php 2,000 for a four day work. paid Php 500 for the tune-up of the service vehicle Paid for the painting supplies purchased Nov. 5. Purchased a new ladder worth Php 5,000 and painting supplies Php 2,900, on account Received Php 4,200 from the customer billed Nov. 12 Received Php 3,400 cash for painting a two-room apartment. Paid Php 5,000 on the note signed for the service vehicle. Paid the assistant Php 1,800 for a three and a half days of work. Withdrew Php 5,000 from the business for personal use 23JR Paints and Design Financial Transaction Worksheet November 30, 20XX ‘ASSETS = LIABILITIES + OWNER’S EQUITY Rosario, Date Cash AR SV PS PE NP AP Cophal Explanation 3Nov 150000 24700 174700 4Nov — -30000 80000 50000 5-Nov 4300 4300 Service 6-Nov 4800 4800 revenue Service TNov 1500 1500 revenue 10-Nov-1600 1600 11-Nov 4800-4800 Service 12-Nov 6200 6200 revenue 13-Nov-2000 -2000 wage expense maintenance 14.Nov — -500 500 expense 18-Nov-4300 -4300 20-Nov 2900 5000 7900 21-Nov-4200 -4200 Service 24.Nov 3400 3400 revenue 27-Nov-5000 5000 28-Nov-1800 1800 wage expense 30-Nov-5000 5000 BAL Php 113700 2000 80000 8800 29700 = 45000 7900 181300 734200 234200 *A/R- Accounts Receivable *SV - Service Vehicle *PS-Painting Supplies *PE-Painting Equipment *NP-Notes Payable *A/P-Accounts Payable 24JR Paints and Designs Statement of Financial Position As of November 30, 20XX ASSETS LIABILITIES and OWNER'S EQUITY Cash Php 113,700 Accounts Payable Php 7,900 Accounts Receivable 2,000 Notes Payable 45,000 Service Vehicle 80,000 Rosario, Capital 181,300 Painting Equipment 29,700 Painting Supplies 8,800 TOTAL Php 234,200 TOTAL JR Paints and Designs Statement of Comprehensive Income for the month ended November 30, 20XX Service Income Php 15900 Less: Operating Expenses Wage Expense Php 3,800 ‘Maintenance Expense 500 (4300) Net Income JR Paints and Designs Statement of Changes in Owner’sEquity for the month ended November 30, 20XX Rosario Capital, November 3 Php 174,700 ‘Add: Net Income 11,600 Less: Rosario Withdrawal (5,000) Rosario Capital, November 30 25JR Paints and Designs Statement of Cash Flows for the month ended November 30, 20XX Cash Flows from Operating Activities Cash Received from Customers Cash paid for expenses Acquisition of Painting Supplies Net Cash Provided by Operating Activities Cash flows from Investing Activities Acquisition of Service Vehicle Net cash used in Investing activities Cash Flows from financing activities Investment by Rosario Withdrawal by Rosario Net Cash provided by Financing Activities Net Increase (Decrease) in Cash Cash Balance at the beginning of the period Cash Balance at the end of the period Php 13900 (4300) 5900) 35000) 150000 5000) Php 3,700 (35,000) 145,000 Php 113,700 Php 113, 700 26SELF-TEST Part I. 1, State the formula of the accounting equation. 2. Explain the three basic questions in analysing a business transaction. 3. What are the three business activities? Give their respective increases and decreases in cash. 4, Discuss the relationship of the financial statements. Part Il. Damon Young has started his own business, Home and Away Inspections. He inspects property for buyers and sellers of real estate. Young rents office space and has a part-time assistant to answer the phone and help with inspections. The transactions for the month of September are as follows: (a) On the first day of the month, Young invested cash by making a deposit in a bank account for the business, P 1,500,000. (b) Paid rent for September, P 10,000. (c) Bought a used truck for cash, P204,000. (d) Purchased tools on account from Crafty Tools, P 139,000. (e) Paid electricity bill, P2,000. (f) Paid two-year premium for liability insurance on truck, P20,000. (g) Received cash from clients for services performed, P52,000. (h) Paid part-time assistant (wages) for first half of month, P8,000. (i) Performed inspection services for clients on account, 40,000. (j) Paid telephone bill, P1,535. (k) Bought office supplies costing P4,300. Paid P1,800 cash and will pay the balance next month, P2,500. (W) Received cash from clients for inspections performed on account in (i), 40,000. (m) Paid part-time assistant (wages) for last half of month, P8,000. (n) Made partial payment on tools bought in (d), P100,000. (0) Earned additional revenues amounting to P67,400: P43,400 in cash and balance on account. (p) Young withdrew cash at the end of the month for personal expenses, P 50,000. REQUIRED 1. Enter the transactions in an accounting equation similar to the one illustrated below: 2, Compute the ending balances for all accounts. 3. Prepare a Balance sheet as of September 30, 20XX. 278 = (u) = 1g. = (w) = reg = a) = yea. = O) = ed = 1) = ea = 0 = reg = (u) 5 rea = (8) = reg. = Q) = ed = @) = ea = ) = rea = (0) = reg = (q) = (e) aid Bumeig yeude> aiqekeg aoueunsu eAlanay uoneuejdxg _sasuadxy sanuanay —‘Buno,_“Buno,_—+_—qunos>y_= yonay sjoo, —_—pledaig sanddns qunossy__yse)_—_ area ‘Aynby s,eumO + SeANIGET == syessy6z WLOL yea. (d) yea (0) yeaBALANCE SHEET 30