MODULE 4- BASIC ACCOUNTING EQUATION

Learning Objectives:

After reading this Information Sheet, you must be able to:

1. Define business transactions

2. Learn about the Accounting Elements
3. Know about the Basic Accounting Equation
4. master Accounting Equation: double entry accounting and the concept of debit and credit
5. Identify what is an account
6. Learn about chart of accounts and its importance

Business Transactions

Business transactions are the raw materials that enter the accounting process and appear in their final form as financial
statements. A transaction is an activity, event, or an action characterized by an exchange of values between two parties and
is states in terms of money (monetary). Note that not all transactions are given accounting recognition. Only those
transactions that are quantifiable or can be stated in terms of money/of value receive accounting recognition.

Since business transactions involve an exchange of values, this implies that there is always a value received which is equal
to the value parted with. This is dual effect of business transactions, which serves as the basis for the bookkeeping system
known as Double Entry Bookkeeping.

The Accounting Elements

A business transaction when given accounting recognition (recorded) should result in a change (increase or decrease) in the
accounting elements. There are three accounting elements, namely: assets, liabilities, and owner’s equity derived from the
basic accounting equation:

Assets = Liabilities +Owner’s Equity

Assets are things that the company owns. They are the resources of the company that have been acquired through
transactions, and have future economic value that can be measured.

Liabilities are obligations of the company; they are amounts owed to creditors for a past transaction and they usually have
the word "payable" in their account title. Along with owner's equity, liabilities can be thought of as a source of the
company's assets. They can also be thought of as a claim against a company's assets. Liabilities also include amounts
received in advance for future services. Since the amount received (recorded as the asset Cash) has not yet been earned, the
company defers the reporting of revenues and instead reports a liability such as Unearned Revenues or Customer Deposits.

Owner's Equity—along with liabilities—can be thought of as a source of the company's assets. Owner's equity is
sometimes referred to as the book value of the company, because owner's equity is equal to the reported asset
amounts minus the reported liability amounts. Owner's equity may also be referred to as the residual of assets minus
liabilities.

"Owner's Equity" is the word used on the balance sheet when the company is a sole proprietorship and Partner’s
Equity for partnership. If the company is a corporation, the words Stockholders' Equity is used instead of Owner's
Equity.

As such, the basic accounting equation may be expanded to show the effect of revenues and expenses as follows:

Assets +Expenses = Liabilities + Owner’s Equity + Revenues

Revenues represent the earnings or gains arising out of the business activities conducted by the firm or business entity.

Expenses represent used up assets necessary for providing the revenues of the firm. These include the cost of goods
sold, SG&A (short for selling, general and administrative) expenses, and interest expense.

The accounting equation that is the foundation of double entry accounting. The accounting equation displays that all
assets are either financed by borrowing money or paying with the money of the company's shareholders. Thus,
the accounting equation is: Assets = Liabilities + Owner’s Equity.

BOOKKEEPING NCIII
Double-Entry Accounting

Under the double-entry system every business transaction is recorded in at least two accounts. One account will receive a
"debit" entry, meaning the amount will be entered on the left side of that account. Another account will receive a "credit"
entry, meaning the amount will be entered on the right side of that account. The initial challenge with double-entry is to
know which account should be debited and which account should be credited.

Because every business transaction affects at least two accounts, our accounting system is known as a double-entry system.
(You can refer to the company's chart of accounts to select the proper accounts. Accounts may be added to the chart of
accounts when an appropriate account cannot be found.)
For example, when a company borrows P100,000.00 from a bank, the transaction will affect the company's Cash account
and the company's Notes Payable account. When the company repays the bank loan, the Cash account and the Notes
Payable account are also involved.

If a company buys supplies for cash, its Supplies account and its Cash account will be affected. If the company buys
supplies on credit, the accounts involved are Supplies and Accounts Payable.

If a company pays the rent for the current month, Rent Expense and Cash are the two accounts involved. If a company
provides a service and gives the client 30 days in which to pay, the company's Service Revenues account and Accounts
Receivable are affected.

Although the system is referred to as double-entry, a transaction may involve more than two accounts. An example of a
transaction that involves three accounts is a company's loan payment to its bank of P 3,000.00. This transaction will
involve the following accounts: Cash, Notes Payable, and Interest Expense.

Debits and Credits

After you have identified the two or more accounts involved in a business transaction, you must debit at least one account
and credit at least one account.

To debit an account means to enter an amount on the left side of the account. To credit an account means to enter an
amount on the right side of an account.

Generally these types of accounts are increased with a debit:

Dividends (Draws)
Expenses
Assets
Losses

You might think of D - E - A - L when recalling the accounts that are increased with a debit.
Generally these types of accounts are increased with a credit:

Gains
Income
Revenues
Liabilities
Stockholders' (Owner's) Equity

You might think of G - I - R - L - S when recalling the accounts that are increased with a credit.
To decrease an account you do the opposite of what was done to increase the account. For example, an asset account is
increased with a debit. Therefore it is decreased with a credit.
The abbreviation for debit is dr. and the abbreviation for credit is cr.

T-Account

The T account is a fundamental training tool in double entry accounting, since you need to see how one side of an
accounting transaction is reflected in another account. This approach is not used in single entry accounting, since only
one account is impacted by each transaction.

BOOKKEEPING NCIII
A T-account is a visual aid used to depict an account in a general ledger. Above the top portion of the T would be the
account title. On the left-side of the base of the T would be any debit amounts; on the right-side would be the credit
amounts.

The T-account can be helpful in determining the proper balance for an account or to determine the amount to be entered in
order to arrive at a desired balance. I always use two (or more) T-accounts when determining how to adjust an account
balance. Drawing two T-accounts reminds us that every transaction or adjustment will have to involve at least two accounts
because of double-entry accounting.

A common use of T-accounts is in preparing adjusting entries (accruals and deferrals). Begin by drawing two T-accounts.

Next, note that one of the T-accounts will affect a balance sheet account. The other T-account is noted as affecting
an income statement account.

Using two T-accounts each time you attempt to determine the proper accounting entry. It will help you see the proper
amounts and the proper accounts.

Normal Balances

When looking at a T-account for each of the account classifications in the general ledger, here is the debit or credit balance
you would normally find in the account:

When Cash is Debited and Credited

Because cash is involved in many transactions, it is helpful to memorize the following:

 Whenever cash is received, debit Cash.

 Whenever cash is paid out, credit Cash.

What is an Account?

To keep a company's financial data organized, accountants developed a system that sorts transactions into records
called accounts. When a company's accounting system is set up, the accounts most likely to be affected by the company's
transactions are identified and listed out. This list is referred to as the company's chart of accounts. Depending on the size
of a company and the complexity of its business operations, the chart of accounts may list as few as thirty accounts or as
many as thousands. A company has the flexibility of tailoring its chart of accounts to best meet its needs.

Within the chart of accounts the balance sheet accounts are listed first, followed by the income statement accounts. In other
words, the accounts are organized in the chart of accounts as follows:

 Assets
 Liabilities
 Owner's (Stockholders') Equity
 Revenues or Income
 Expenses

BOOKKEEPING NCIII
  Gains
 Losses

An example of Chart of Accounts:

Wedding “R” Us
Chart of Accounts

Assets
110 Cash
120 Accounts Receivable
130 Supplies
140 Prepaid Rent
150 Prepaid Insurance
160 Service Vehicle
165 Accumulated Depreciation
170 Office Equipment
175 Accumulated Depreciation

Liabilities
210 Notes Payable
220 Accounts Payable
230 Salaries Payable
240 utilities Payable
250 Interest Payable
260 Unearned Referral Revenues

Owner’s Equity
310 Diaz, Capital
320 Diaz, Withdrawals
330 Income Summary

Income
410 Consulting Revenues
420 Referral Revenues

Expenses
510 Salaries Expense
520 Supplies Expense
530 Rent Expense
540 Insurance Expense
550 Utilities Expense
560 Depreciation Expense- Service Vehicle
570 Depreciation Expense- Office Equipment
580 Miscellaneous Expense
590 Interest Expense

BOOKKEEPING NCIII