Analyzing Business Transaction

Part 2
• The success or failure of a business depends on its financial
performance. This information is provided by the income statement
which summarizes the operating activities of the business. This
module starts with a discussion of the operating guidelines for
recognition of revenues and expenses as provided in the Framework.
It will also demonstrate the effects in recognizing income and
expenses on the assets and liabilities. Finally, it ends with the
preparation of the financial statements.
Accrual Concept of Recognizing Revenues and Expenses

• The Accrual concept is supported by the Realization Principle and

Expense Recognition Principle.

• The Realization of Revenue principle recognizes revenue when it is

earned regardless of collection.

• The Recognition of Expense principle recognizes expenses follows the

same rule as recognizing revenues, that is payment in cash or in
property is generally not a requirement.
Accrual Concept vs Cash Concept
• Accrual Assumption
The Accrual Assumption as provided
in PAS 1 par. 25-26 requires that
revenues and expenses be
recognized based on the time period
they relate or based on the
occurrence of the revenue and
expenses rather than on whether
cash is received or paid.
• Cash Concept
In contrast, the Cash Concept
recognizes revenue only when cash
is collected and expenses only when
cash is paid. This concept is
applicable for a small business which
has short operating cycle and where
the focus of attention may be more
on liquidity or short term cash
position of the firm.
Operating a Business for Profit

• In this module, the accounting equation which was explained and

demonstrated in the last module will be expanded to include changes
in the owner’s equity or capital because of the operating activities.

• Figure provided in the next slide shows the expanded structure of an

accounting equation with the owner’s equity affected by four
elements: contributions and revenues on one hand (increasing
owner’s equity), withdrawals and expenses on the other hand
(decreasing owner’s equity).
Expanded Structure of a Business

ASSET = LIABILITY + OWNER‘S EQUITY

Increase due to: Decreases due to:

1. Contributions 1. Withdrawal
2. Income 2. Expenses
INCOME

• An income represents inflows of cash or other assets coming from a

client or customer for service rendered or for merchandise sold. The
definition of income encompasses revenues and gains.

• Revenue is income coming from the normal course of business.

• Gain is an income which may arise but not really from its normal
course of operation.
INCOME

• PAS 1 defines income as an increase in economic benefits during the

period that results in increase in equity, other than those resulting
from contributions of equity participants (investors). An increase in
economic benefits may take the form of cash inflow or enhancement
of assets or decrease in liabilities.
EXPENSES

• A business cannot operate to earn revenue without consuming some

assets or using up the services of other businesses or persons. The
consumption of asset or using up of services to generate revenue is
called an expense.

• An expense will decrease an asset or increase a liability with a

corresponding decrease in owner’s equity.
EXPENSES

• PAS 1 defines expenses as a decrease in economic benefit during the

accounting period that results in a decrease in equity, other than
those relating to distributions to equity participants (in the form of
personal drawings made by the owner). Decrease in economic benefit
may be in the form of outflow of cash or depletion of asset or
increase in liabilities.
Profit or Loss

• The difference between the total income earned and the total
expenses incurred spells the success or failure of the organization. If
income is greater than expenses, the result is profit. The relationship
of these items, suing the illustrated figures for revenues and
expenses, may be expressed as follows:

REVENUES - COSTS AND EXPENSES = NET INCOME (NET LOSS)

Effect of Net Income on the Accounting Values

• Effect in the accounting equation (assuming only two transactions

took place: P15,000 revenues collected in cash and P5,000 expenses
paid in cash):
Increase in Owner’s
Increase in Assets =
Equity

Cash P10,000 Net Income P10,000

Medical fees (P15,000) less

Expenses (P5,000)
Effect of Net Loss on the Accounting Values

• When the total amount of expenses incurred (say 15,000) is greater

than the total amount of revenues earned (say 10,000) a net loss of P
5,000results which decreases both the assets and the owner’s equity.
Demonstration Problem 2
Happy Tour and Travel
Transactions during March 2020
Received cash for revenue earned.

• March 21 A tourist hired the services of the agency for a tour in

Baguio. Cash of P15,000 was received from the tourist.

Increase in ASSETS = LIABILITIES + Increase in OWNER’S EQUITY

Cash P 15,000 Service Income P 15,000

Paid cash for expenses incurred.

• March 22 Cash was paid for the following: gas and oil, P500 and
repair of car, P1,000.

Decrease in ASSETS = LIABILITIES + Decrease in OWNER’S EQUITY

Cash P 1,500 Repairs Expense P 1,000

Gas & Oil Expense 500
Revenue rendered on account

• March 24 Mr. Gray hired the services of the agency for his visitors
and promised to pay P16,000 on March 31.

Increase in ASSETS = LIABILITIES + Increase in OWNER’S EQUITY

Accounts Receivable P16,000 Service Income P 16,000

Paid cash for expense incurred.

• March 25 Paid telephone bill for P 500.

Decrease in ASSETS = LIABILITIES + Decrease in OWNER’S EQUITY

Cash P 500 Utilities Expense P 500

Revenue earned with a down payment, balance on account.

• Mar 27 The Faculty Club of Angelicum Academy hired the services

of the agency for a tour in Manila. A bill was issued to
them for P20,000, 50% of which was collected.

Increase in ASSETS = LIABILITIES + Increase in OWNER’S EQUITY

Cash P 10,000 Service Income P 20,000

Accounts Receivable 10,000
Customer’s account collected in cash.

• March 30 Mr. Gray paid one half of his account in cash.

Increase & Decrease in ASSETS = LIABILITIES + OWNER’S EQUITY

Cash P 8,000
Accounts Receivable (8,000)
Paid cash for expenses incurred

• March 31 Paid for rental of office space, P10,000 and salaries of

employees and workers P9,000.

Decrease in ASSETS = LIABILITIES + Decrease in OWNER’S EQUITY

Cash P 19,000 Rent Expense P 10,000

Salary Expense 9,000
Activity:

• Prepare an Income Statement, Statement of Cash Flow, Capital

Statement and Statement of Financial Position for Happy Tour and
Travel from Demonstration Problem 1 & 2.
Solution:
• Income Statement shows total revenues earned P51,000 and total
expenses incurred P21,000 resulting in a net income of P30,000
which was carried forward to the capital statement.
Solution: (cont.)
Solution: (cont.)

• Capital Statement shows the starting capital of the owner of

P800,000 which increased by P30,000 because of net income and
decreased by P 5,000 because of the owner’s personal drawings. The
ending capital became P825,000 which was brought forward to the
statement of financial position as claim over the net assets.
Solution: (cont.)
Solution: (cont.)

• Statement of Financial Position shows the assets owned by the

business of P925,000 of which P100,000 represented as claim of the
creditors and P825,000 as claim of the owner.
Solution: (cont.)
Solution: (cont.)

• The Statement of Cash Flows shows the changes in the cash activities
starting with the operating activities found in the income statement,
and the investing and financing activities found in the statement of
financial position.
Statement of Cash Flows

• IAS No. 7 revised 2007 requires the preparation for a certain period of
time. This summarizes the cash activities of the business: Cash
inflows or sources of cash and cash outflows or uses of cash. Of what
is this statement?

1. For evaluating cash stewardship of the finance officer,

2. Used as a guide in planning future cash flows, and
3. For assessing the ability of generating cash from operating activities.
CLASSIFICATION OF ASSETS

• Current Assets include cash and cash equivalents which are not
restricted in use, as well as other assets expected to be realized into
cash, or sold or consumed within the normal operating cycle of the
business or one year, whichever is longer.

• Non-Current Assets are in the form of plant, property and equipment.

CLASSIFICATION OF LIABILITIES

• Current Liabilities are those debts or obligations reasonably expected

to be liquidated in the normal course of the enterprise’s operating
cycle or paid within a period of one year by the use of current assets
or the creation of other current liabilities.

• Non-Current Liabilities are long term liabilities or obligations which

are payable longer than one year such as Mortgage Payable and
Bonds Payble.
OPERATING CYCLE

• This represents the period of time it takes for cash to be converted

back into cash. PAS 1.68 defines it as the time between the
acquisition of assets, their processing and realization in cash or cash
equivalent. It depends upon the type of operation as shown in figure
in the next slide.
• This information is relevant in classifying assets and liabilities of the
equity into current and non-current and also in the planning function
of management which is discussed in Management Accounting and in
Financial Management. The operating cycle for a travel agency may
take three months while that of a wine manufacturer may take more
than a year.
Operating Cycle for Service Business

Cash

Service
Account
rendered
collected on account
Operating Cycle for Merchandising Business

Cash

Account Merchandise
collected Purchased

Merchandise
sold on
account
Operating Cycle for Manufacturing Business

Cash

Raw
Account
Materials
Collected
purchased

Finished Raw materials

processed
goods sold into Finished
on Account Goods
SOURCE:
• 21st Century Accounting Process; 2015 edition, by Zenaida Vera Cruz-
Manuel
Thank you ☺