Our Lady of the Pillar College – San Manuel, Inc.

District 3, San Manuel, Isabela

COLLEGE OF ACCOUNTANCY

THE ACCOUNTING EQUATION

Financial Accounting and Reporting
FAR - 02

BASIC ELEMENTS OF ACCOUNTING

a. Financial Position (Balance Sheet).
1. Assets. These are resources controlled by the enterprises as a result of past transactions or events and from
which future economic benefits are expected to flow to the enterprise.
2. Liabilities. These are present obligations of the enterprise arising from past transactions or events, the
settlement of which is expected to result in an outflow from the enterprise embodying economic benefits.
3. Equity. It is the residual interest in the assets of the enterprise after deducting all its liabilities.
b. Results of Operations (Income Statement).
1. Revenues. These are the gross inflows of economic benefits during the period arising in the course of
ordinary activities of an enterprise when those inflows result in increases in equity, other than those relating
to contribution from owners. They are inflows of future economic benefits that increase equity, other than
contributions or investment by owners.
2. Expenses. These are the gross outflows of economic benefits during the period arising in the course of
ordinary activities of an enterprise when those outflows result decreases in equity, other than those relating
to distribution to owners. They are consumption or outflows of future economic benefits that decrease
equity, other than distributions or dividends aid to owners.
3. Net Income. It is the amount by which total revenues exceed total expenses for the period. When expenses
exceed revenues, the result is a net loss.

TYPICAL ACCOUNT TITLES USED

Balance Sheet
1. Assets.
a. Current Assets. These are all assets that are expected to be realized, sold or consumed within the
enterprise’s normal operating cycle. Operating cycle is the interval time from the date of acquisition of
merchandise inventory; sell the inventory to customers and the ultimate collection of cash from the sale.
 CASH. It is any medium of exchange that a bank will accept at face value. It includes coins,
currency, checks, money orders, bank deposits and drafts. The cash within the premises of the
business is CASH ON HAND while the cash deposited in the bank is CASH IN BANK.
 PETTY CASH FUND. This represent money places and set aside for “petty” or small expenses.
 CASH EQUIVALENTS. These are short-term, highly liquid investments that are readily
convertible to cash and with original maturities of three months or less.
 ACCOUNTS RECEIVABLE. Claims from customers arising from goods sold or services
rendered on credit. It represents the debtor’s oral promises to pay a client.
 NOTES RECEIVABLE. It is a written pledge that the customer will pay the business at fixed
amount of money on a certain date.
 ALLOWANCE FOR DOUBTFUL ACCOUNTS. This is an “asset offset” or “contra asset”
account which provides for possible losses from uncollected accounts receivable.
 MERCHANDISE INVENTORY. Goods purchased by the business to be sold at a profit.
 SUPPLIES. Miscellaneous supplies that have been bought for office use but are still unused as of
the balance sheet date.
 PREPAID INSURANCE. Already paid insurance premiums which are applicable in the future
periods.
b. Noncurrent Assets.
 LAND. Land owned and used by the business entity.
 BUILDING. Building owned and used by the business in its operation.
 EQUIPMENT. It records the acquisition and disposition of office machines, desks, cars, trucks,
file cabinets and similar items.
 FURNITURE AND FIXTURES. It includes office tables, chairs, etc.

2. Liabilities.
a. Current Liabilities. There are financial obligations of the enterprise which are expected to be settled in the
normal course of the operating cycle; due to be settled within one year from the balance sheet date.
 ACCOUNTS PAYABLE. Amounts due to the creditors for the goods or service bought in credit.
 NOTES PAYABLE. Amounts due to the creditors which are supported by a promissory note.
 ACCRUED LIABILITIES. Amounts owed to other unpaid expenses. These include salaries
payable, interest payable and taxes payable.

FINANCIAL ACCOUNTING AND REPORTING 1

  UNEARNED REVENUES. When the business entity receives payment before providing its
customers with goods or services, the amount received are recorded in the unearned revenue
account. When the goods or services are provided to the customer, the unearned is reduced and
revenue is recognized.
b. Noncurrent Liabilities. These are financial obligation of the enterprises which are due and payable for more
than one year.
 MORTGAGE PAYABLE. This includes long-term debts for the business entity for which the
business entity has pledged certain assets as security to the creditor.
3. Owner’s Equity.
 CAPITAL. Amount of capital contributions of the owner to the business.
 WITHDRAWALS. Amount withdrawn by the owner from the assets of the business for personal
use.
 INCOME SUMMARY. It is a temporary account used at the end of the accounting period to
close revenues and expenses.

Income Statement
1. Revenues.
 SERVICE REVENUE. Revenues earned by performing services for a customer or client.
 SALES. Revenues earned as a result of sale of merchandise.
2. Expenses.
 COST OF SALES. Cost of goods purchased and sold or materials manufactured and sold.
 SALARIES AND WAGES EXPENSE. Payments as a result of an employer-employee
relationship.
 UTILITIES EXPENSE. Amount of telephone, light and water consumed by the business.
 RENT EXPENSE. Expense for space, equipment or other asset rentals.
 SUPPLIES EXPENSE. Expense of using supplies in the conduct of daily business.
 INSURANCE EXPENSE. Premiums paid on insurance coverage.
 DEPRECIATION EXPENSE. The portion of the cost of a tangible asset allocated or charged as
expense during the accounting period.
 DOUBTFUL ACCOUNTS EXPENSE. The amount of receivable estimated to be doubtful of
collections and charged as expense during an accounting period.
 TAXES AND LICENSES. The amount paid for business permits, licenses and other government
dues.

THE ACCOUNTING EQUATION

In a double entry system, for every debit, there must be a credit, and vice versa. This leads to the basic equation in
accounting. The relationship of assets, liabilities and owner’s equity of a business enterprise is expressed in the accounting
equation:

ASSETS = LIABILITIES + OWNER’S EQUITY

The equation shows that the ownership of the assets of the business is divided between the rights of the creditors and the
rights of the owners of the business. The creditors have first claim on the assets of the business.

The accounting equation could be stated in another way to emphasize the residual interest of the owner over the assets of the
business at the point of liquidation.

ASSETS – LIABILITIES = OWNER’S EQUITY

To include the income and expense as temporary accounts together with drawing, the accounting equation is expanded and
restated as follows:

ASSETS = LIABILITIES + OWNER’S EQUITY (- Drawing + Income – Expense)

Every time a transaction occurs, the elements of the accounting change, however, the basic equality remains.

To illustrate, consider the following different transactions of ABC Services, Inc.

1. Owner invests P150,000 cash in the business.

Assets = Liabilities + Equity

+150,000 = +150,000

2. Purchase office equipment at P40,000 on account.

Assets = Liabilities + Equity

+40,000 = +40,000

3. Received P12,000 cash for services rendered.

Assets = Liabilities + Equity

+12,000 = +12,000
FINANCIAL ACCOUNTING AND REPORTING 2
4. Paid P25,000 for the account in No. 2 transaction.

Assets = Liabilities + Equity

-25,000 = -25,000

5. Billed a customer for services rendered P16,000.

Assets = Liabilities + Equity

+16,000 = +16,000

6. Paid P8,000 for salaries of employee.

Assets = Liabilities + Equity

-8,000 = -8,000

FINANCIAL TRANSACTION WORKSHEET

Every financial transaction can be analyzed or expressed in terms of its effects on the accounting equation. A financial
transaction worksheet is used to analyze increases and decreases in assets, liabilities or owner’s equity.

Illustrative Problem
DEF decides to open a tailoring shop on July of the current year called DEF Tailoring.
1. On July 1 of the current year, he invested P760,000 cash to start his tailoring shop.
2. On July 3, DEF acquired equipment worth P450,000 from GHI Sewing Machine. Singer allows DEF to pay for the
acquisition later.
3. DEF acquired supplies by paying P45,000 cash.
4. On July 10, DEF paid GHI Sewing Machine P50,000.
5. On July 12, DEF received P48,000 cash from customers for tailoring services.
6. On July 14, DEF provided tailoring services of P70,600 to customers on account.
7. Expenses paid in cash for July are salaries of employees, P60,400.
8. The sum of P70,600 was received from customers who have been billed for services on July 14.
9. DEF withdraws P26,000 for personal use.
10. A count of supplies on July 31 indicates that P12,000 of sewing supplies have been used.

Required: Record the above transactions using the format below:

Transaction Cash Equipment Supplies Accounts Accounts DEF, Capital

Receivable Payable
1
2
3
4
5
6
7
8
9
10
TOTAL
Effects of Transactions on the Accounting Equation
Business transactions affect the assets, liabilities and owner’s equity of an enterprise. Each transaction always has a two-fold
effect and both of this should be recorded to keep the equation in balance. These transactions may be grouped into nine types
of effects as follows:
1. Increase in Asset = Increase in Owner’s Equity
2. Increase in Asset = Increase in Liability
3. Increase in One Asset = Decrease in Another Asset
4. Decrease in Asset = Decrease in Liability
5. Decrease in Asset = Decrease in Owner’s Equity
6. Increase in One Liability = Decrease in Owner’s Equity
7. Increase in One Liability = Decrease in Another Liability
8. Increase in Owner’s Equity = Decrease in Liability
9. Increase in One Owner’s Equity = Decrease in Another Owner’s Equity

THE T-ACCOUNT
Business transactions cause increases and decreases in the accounting values. To record these changes, a business firm makes
use of T-accounts. A T-account is an accounting device to summarize the increase and decrease in the asset, liability and
equity of the business.

ACCOUNT TITLE

Left Side Right Side

FINANCIAL ACCOUNTING AND REPORTING 3

The terms debit (Dr.) and credit (Cr.) mean left and right, respectively. These terms do not mean increase or decrease but
instead describe where a company makes entries in the recording process. That is, when a company enters an amount on the
left side of a T-account, it debits the account. When it makes an entry on the right side, it credits the account. When
comparing the totals of the two sides, an account shows a debit balance if the total of the debit amount exceeds the credits.
An account shows a credit balance if the credit balance exceeds the debits.

The equality of debits and credits provides the basis for the double-entry system of recording transactions (sometimes
referred to as double entry bookkeeping). Under the universally used double entry accounting system, a company records the
dual (two-sided) effect of each transaction in appropriate accounts. This system provides a logical method for recording
transactions. If a company records every transaction with equal debits and credits, then the sum of all debits to the accounts
must equal the sum of all the credits.

Rules of Debit and Credit

The rules on debits and credits are patterned after the accounting equation:

ASSETS = LIABILITIES + OWNER’S EQUITY (- Drawing + Income – Expense)

Assets. Since assets are on the left side of the accounting equation, its increases are recorded on the debit side and its
decreases are on the credit side. Asset accounts should normally have debit balances.

Rule: Debit to increase an Asset and credit to decrease an Asset.

Liabilities. Since liabilities and owner’s equity are recorded on the right side of the equation, their increases are recorded on
the credit side and their decreases are on the debit side. Liability accounts should normally have credit balances.

Rule: Credit to increase a Liability and debit to decrease a Liability.

Owner’s Equity (Capital). The owner’s equity account is used to determine the owner’s permanent investment in the
business. Since it is on the right side of the equation, it is increased by credits and decreased by debits. The capital account
should have a normal credit balance. However, the capital account may have a debit balance as a result of business losses.

Rule: Credit to increase an Owner’s Equity and debit to decrease an Owner’s Equity.

Owner’s Equity (Drawing). The owner of a business enterprise may withdraw cash or other asset for his personal use. The
owner who is considered a separate entity from the business decreases his equity whenever he makes a withdrawal of
business assets. Withdrawals decrease owner’s equity. Since withdrawals decrease owner’s equity, the drawing account is
increased by debits and decreased by credits. It has a normal debit balance.

Rule: Debit to increase Drawing and credit to decrease Drawing.

Revenues. Revenues are subdivision of owner’s equity that provides information as to why the owner’s equity is increased.
Since revenues increase owner’s equity, they are recorded on the right side or credit side. Decrease in revenues are recorded
on the debit side. Revenues have normal credit balances.

Rule: Credit to increase a Revenue and debit to decrease a Revenue.

Expenses. Expenses decrease owner’s equity. Decreases in owner’s equity are recorded on the debit side. It also follows that
increases in expenses are recorded on the debit side and decreases in expensed are recorded on the credit side. Expenses have
a normal credit balances.

Rule: Debit to increase an Expense and credit to decrease an Expense.

The rules of debit and credit can be summarized as follows:

Debit to: Credit to:

1. Increase Assets 1. Decrease Assets
2. Decrease Liabilities 2. Increase Liabilities
3. Decrease Owner’s Equity due to: 3. Increase Owner’s Equity due to:
- Withdrawal by the owner - Investment by the owner
- Increase in expenses and losses - Decrease in expenses and losses
- Decrease in income - Increase in income

Illustrative Problem
JKL opened a catering services he called “Malinis Catering”.

FINANCIAL ACCOUNTING AND REPORTING 4

 Dec 1 JKL invested P940,000 cash and equipment, P100,000.
4 He purchased kitchen utensils, tools and additional equipment from MNO Trading Credit, P240,000.
7 Paid for advertisement announcing the opening of his business, P15,000.
9 Paid one-half of the account due to MNO Trading.
11 Rendered catering service to PQR’s wedding and received cash of P125,000.
13 Paid for the food supplies used in PQR’s wedding party, P52,300.
17 Billed STU, P80,800 for catering service rendered in his birthday party.
20 Paid the salary of the assistant cook, P56,000.
22 Received from STU the amount of P45,000 as partial payment of the account due to him.
23 Withdrew P17,000 for his personal use.

Required: Record the above transactions using the format below:

Transaction Cash Accounts Equipment Accounts JKL, Capital JKL,

Receivable Payable Withdrawal
Dec. 1
Dec. 4
Dec. 7
Dec. 9
Dec. 11
Dec. 13
Dec. 17
Dec. 20
Dec. 22
Dec. 23
TOTAL

Required: With the aid of T-accounts, record the transaction listed above. Use the following accounts:
- Cash - Accounts Payable
- Accounts Receivable - JKL, Capital
- Equipment - JKL, Withdrawal

FINANCIAL ACCOUNTING AND REPORTING 5