The Accounting Equation and the Double Entry System _|_2-17 ACCOUNTING FOR BUSINESS TRANSACTIONS Accountants observe many events that they identify and measure in financial terms. A (Business transaction is the occurrence of an event or a condition that affects financial Position and can be reliably recorded. Financial Transaction Worksheet Every financial transaction can be analyzed or expressed in terms of its effects on the accounting equation. The financial transactions will be analyzed by means of a financial transaction worksheet which is a form used to analyze increases and decreases in the assets, liabilities or owner's equity of a business entity. Illustration. Emerita Modesto decided to establish a sole proprietorship business and named it as Modesto Graphics Design. Modesto is a graphic designer who has extensive experience in drawing, layout, typography, lettering, diagramming and Photography. She possesses the talent to visually communicate to a target audience with the right combination of words, images and ideas. Modesto Graphics Design can do the layout and production design of newspapers, magazines, corporate reports, journals and other publications. The entity can create Promotional displays; marketing brochures for services and products; packaging design for products; and distinctive logos for businesses. She also enters into agreements with clients for the progressive development and maintenance of their web sites. Her initial revenue stream comes from web designing. The owner, Emerita Modesto, makes the business decisions. The assets of the company belong to Modesto and all obligations of the business are her responsibilitv. Anv income that the entity earns belongs solely to Modesto. |When ‘a specific asset, liability or owner's equity item is created by a financial! | transaction, it is listed in: the financial transaction worksheet using the /appropriate) ‘accounts. The worksheet that follows shows the first transaction of the Modesto Graphics Design. The dates are enclosed in parentheses. During March 2021, the first month of operations, various financial transactions took place. These transactions are described and analyzed as follows: Mar. 1 . Modesto started her new business by depositing P350,000 in a bank account in the name of Modesto Graphics Design at BPI Poblacion Branch,2-18 | Basic Financial Accounting and Reporting 2022 Edition by Prof. WIN Ballada Modesto Graphics Design Financial Transaction Worksheet Month of March 2021 Assets, = Liabili + Owner's Equity t Cash . Modesto, Capital (1) __P350,000 = 350,000 The financial transaction is analyzed’as follows: + Anentity separate and distinct from Modesto’s personal financial affairs is created, * An economic resource—cash of P350,000 is invested ift the business entity. The source of this asset is the contribution made by the owner, which represents owner's equity. The owner's equity aécount is Modesto, Capital. + The dual nature of the transaction is that cash is invested and owner's equity created. The effects on the accounting equation are as follows: increase in asset— cash from zero to P350,000 and increase in owner's equity'from zero to P350,000. + Atthis point, the entity has no liabilities, and assets equal owner’s equity. Mar.5 Computer equipment costing P'145,000 is acquired on cash basis. The effect of the transaction on the basic equation is: Assets = + Owner's Equity Cash + Computer, oI Modesto, Capital Equipment Bal. 350,000 = 350,000 (5) (145,000) P145,000 Bal. P205,000 + P145,000 350,000. 350,000 This transaction did not change the total assets but it did change the composition of the assets—it decreased one asset—cash and increased another asset—computer -@quipment by P145,000: Note that the sums of the balances on both sides of the equation are equal. This equality must always exist. Mar.9 Computer supplies in the amount of P25,000 are purchased on account. Assets = Liabilities + Owner's Equity Cash + Computer + Computer = Accounts + Modesto, Capital Supplies Equipment Payable Bal. P205,000 P145,000 = 350,000 (9) 25,000 = P.25,000_ Bal. — 205,000. + _P25,000 + P4500 = __P 25,000. + 350,000 7375,000_ = _P575,000_— The Accounting Equation and the Double Entry System | 2-19 Assets don’t have to be purchased in cash. It can also be purchased on credit. Acquiring the computer supplies with a promise to pay the amount due later is called (buying én . This transaction increases both the assets and the liabilities of the business. The asset affected is computer supplies and the liability created is an accounts payable. Mar. 11 Modesto Graphics Design collected P88,000 in cash for designing interactive web sites for two exporters based inside the ASEAN Ecozone. Assets = Labi + Owner's Equity a Cash + Computer + computer =. Accounts + Modesto, Supplies Equipment Payable Capital Bal. —P205,000 25,000 P145,000 = 25,000" 350,000 (11) 88,000 = 88,000 Bal. __P293,000_ + P25,000 + P145,000. = P25,000_ + 438,000 P463,000_ «= The entity earned service income by designing web sites for clients. Modesto rendered her professional services and collected revenues in cash. The effect on the accounting equation is an increase in the asset—cash and an increase in owner's equity. Income increases owner’s equity. This transaction caused the business to grow, as shown by the increase in total assets from P375,000 to P463,000. Mar. 16 Modesto paid P18,000 to MVP Bills Express, a one-stop bills payment service company, for the semi-monthly utilities. Assets liabilities + Owner's Eq Cash +, Computer + Computer = Accounts + Modesto, Capital Supplies Equipment Payable ‘ Bal. —P293,000 25,000 P145,000 = 25,000 438,000 (16) __ (18,000) : . (18,000) Bal. __P275,000_ + __P25,000_ + __P145,000_ = P25,000_ + 420,000 P445,000_ = 445,000 re recorded when they are incurred? Expenses can be paid in cash when they ‘occur, or they can be paid later. The payment for utilities is an expense for the month of March: It represented an outflow of resources and a reduction of owner's equity. Expenses have the opposite effect of income; they cause the business to shrink as shown by the smaller amount of total assets of P445,000. . Mar.17 The entity has service agreements with several Netpreneurs to maintain and update their web sites weekly. Modesto billed these clients P35,000 for services already rendered during the month.WIN Ballada 2Q | Basic Financial Accounting and Reporting 2022 Edition by Pro} ' j A = L + OE Cash. + Accounts + Computer + Computer =. Accounts Mode Receivable Supplies Equipment Payable pital Bal. P275,000 25,000 14500 = —P25,000 420.00 (17) 35,000 ; 5,000 Bal. _ 275,000 + P35,000_ + P2500. + 145,000 = __P25,000_ + __PAS5,000 480,000 480,000, The entity has performed services to clients/so income should already be recognized, Modesto is entitled to receive payment for these but the clients did not pay immediately. Performing the services creates an economic resource, the clients’ Promise to pay the amount which is called accounts receivable. This transaction resulted to an increase in an asset—accounts receivable and an increase in owner's equity of P35,000. Mar. 19 Modesto made a partial payment of P17,000 for the Mar. 9 purchase on account. A = L + OE Cash . + Accounts + Computer + Computer = Accounts + Modesto, Receivable Supplies Equipment Payable Capital Bal. P275,000 35,000 25,000 P145,000 = — 25,000 455,000 (19) __ (17,000) = ___(17,000) Bal. __P258,000_ + P35,000 + P25,000 + P145,000. = P8,000_ + P455,000 P463,000_ = _P463,000 This transaction is a payment on account. The effect on the accounting equation is 2 decrease in the asset—cash and a decrease in the liability—accounts payable. The payment of cash on account has no effect on the asset—computer supplies because the payment does not increase or decrease the supplies available to the business. Mar. 20 Checks totaling P25,000 were received from clients for billings dated Mar. 17- A 8 eel 4 POE Hy Cash + Accounts + Computer + Computer = Accounts + Modesto, , Receivable ‘Supplies Equipment Payable Capital Bal.’ 258,000 P35,000 25,000 145,000 P8,000 455,000 (20) 25,000 (25,000) Bal. __P283,000. + __P10,000_ + __P25,000 + _P145,000 P8,000_ + _ pass 000 P463,000_- = 463,000The Accounting Equation and the Double Entry System | Last Mar. 17, Modesto billed clients for services already rendered. On Mar. 20, the entity was able to collect P25,000 from them. The asset—cash is increased by P25,000. The business should not record service income on Mar. 20 since it has already recorded the income last Mar. 17. Total assets are unchanged. The business merely reduced one asset—accounts receivable and increased another—cash. Mar. 21 Modesto withdrew P20,000 from the business for her personal use. A = L + OE Cash + Accounts + Computer + Computer = Accounts + Modesto, . Receivable ‘Supplies Equipment Payable Capital Bal. 283,000 P10,000 25,000 P145,000 = P8,000 455,000 (21) ___ (20,000) (20,000) Bal. __P263,000 + P10,000 + 25,000 + _P145,000 P8,000_ + _P435,000 Withdrawal of cash or other assets for personal use is the way by which the owner of the entity receives advance distribution of the profits. On Mar. 1, Modesto invested P350,000; both cash and owner's equity increased. The transaction was an investment by the owner and not an income-generating activity. Modesto simply transferred funds from her Personal account to the business. A cash withdrawal-is exactly the opposite. The P20,000 cash withdrawal transaction resulted to a reduction in both cash and owner's equity. Mar. 27. Alessandra Publishing submitted a bill to Modesto for P8,000 worth of newspaper advertisements for this month. Modesto will pay this bill next month. A Sb + OE Cash + Accounts + Computer + Computer = Accounts + Modesto, Receivable Supplies Equipment Payable Capital Bal. _ P263,000 10,000 25,000 P145,000 = =P 8,000 * 435,000 (27) - = 8,000 (8,000) Bal. _ P263,000_ + P10,000_'+ __P25,000_ + P145,000 = __P16,000_ + 427,000 443,000 = 443,000 Alessandra rendered services on account. Modesto Graphics Design has incurred an expense in the amount of P8,000 by availing of Alessandra's services. There was no payment during the month. This advertising expense resulted to a decrease in owner's j equity and an increase in the liability—accounts payable. ‘2-22 | Basic Financial Accounting and Reporting 2022 Edition by Prof. WIN Ballada Mar. 31 Modesto paid her assistant designer salaries of P15,000 for the month. A = L + OE Cash + Accounts + Computer + Computer = Accounts + Modesto, Receivable ‘Supplies Equipment Payable Capital Bal. — P263,000 10,000 25,000 145,000 = — P16,000 427,000 (28) ___ (15,000) = (25,000) Bal. _P248,000 + P10,000 + P2500 + P145,000 = P16000 + P412,000 428,000 = _ P428,000 This transaction resulted to a reduction in owner's equity as well as a reduction in cash, By providing her services to Modesto for the month, the assistant designer has created for the business an expense—salaries expense. (Use of T-Accounts Analyzing and recording transactions using the accounting equation is useful in conveying a basic understanding of how transactions affect the business. However, it is not an efficient approach once the number of accounts involved increases. Double- entry system provides a, formal system of classification’ and recording business transactions. Mlustration. The rules of debit and credit will be applied to the Modesto Graphics Design illustration for comparison. Three transactions will be added to the example. Before being recorded, a transaction must be analyzed to determine which accounts must be increased or decreased. After this has been determined, the rules of debit and credit are applied to effect the appropriate increases and decreases to the accounts. Mar.1 — Modesto started her new business by depositing P350,000 in a bank account in the name of Modesto Graphics Design at BP! Poblacion Branch. Assets (Increase) = Cash Modesto, Capital Debit Credit Debit Credit (+) 0) 0 (+) 3-1 350,000 Owner's Equity (Increase) 3-1 350,000 This transaction increased both the asset—cash and owner's equity. According to the ityand credit, an increase in asset is recorded as debit’ while an iricrease in “Owner's equity is recorded as credit; thus, the entry is to debit cash and to credit Modesto, Capital. The transaction dates are placed on the left side of the amounts for (reference,—— The Accounting Equation and the Double Entry System | 2-23 Mar. 2 Computer equipment is acquired by issuing a P50,000 note payable to Paco Roman Office Systems. The note is due in six months. Assets (Increase) = Liabilities (Increase) Computer Equipment . Notes Payable Debit Credit Debit Credit *) 0 0 ) 32 50,000 3-2 50,000 The transaction increased by P50,000 the asset—computer equipment and the liability—notes payable. Computer equipment must be debited and notes payable must be credited. Mar.3 — Modesto paid P15,000 to Del Rosario Suites for rent on the office studio for the months of March, April and May. Assets (Decrease) i Assets (Increase) Cash Prepaid Rent Debit Credit Debit Credit (+) () (+) t) a4 350,000 | 3-3 15,000 33 15,000 The entity paid advance rent for three months. A resource having future economic benefit—prepaid rent, is acquired for a cash payment of P15,000._ Increases in assets are recorded by debits and decreases in assets are recorded by credits. The transaction resulted to a debit to prepaid rent and a credit to cash for P15,000. The prepaid rent is consumed based on the passage of time so that after one month, P5,000.of the prepaid rent will be transferred to the rent expense account. Mar.4 — Received advance payment of P18,000 from Marco Polo ASEAN Hotel for web site updating for the next three months. Assets (Increase) = Uabilities (Increase) Cash Unearned Revenues: Debit Credit Debit credit (+) 2) 4) (+) 34 350,000 | 3-3 15,000 34 18,000 34 18,000 The entity has an obligation to Marco Polo ASEAN Hotel for the next three months. This (liability is calledfunearned revenues) The asset—cash is increased by a debit of P18,000 and the liability—unearned revenues is increased by a credit of P18,000. As it renders service, the entity discharges its obligation at a rate of P6,000 per month for the next three months.2-24 | Basic Financial Accounting and Reporting 2022 Edition by Prof. WIN Ballada Mar.5 Computer equipment costing P145,000 is acquired on cash basis. Assets (Decrease) = Assets (Increase) Cash Computer Equipment Debit Credit Debit Credit (+) () (+) 0 34 350,000 | 3-3 15,000 32 50,000 34 18,000 | 3-5 145,000 35 145,000 This transaction increased the asset—computer equipment and decreased the asset— cash. Assets are increased by debits and decreased by credits; thus, computer equipment is debited and cash is credited for P145,000. Mar.9 Computer supplies in the amount of P25,000 are purchased on account. Assets (Increase) = Liabilities (Increase) Computer Supplies Accounts Payable Debit Credit Debit Credit (+) 0 a (+) 39 25,000 39 25,000 The asset—computer supplies is increased by a debit of P25,000 while the liability account—accounts payable is increased by a credit for the same amount. Mar. 11 Modesto Graphics Design collected P88,000 in cash for designing web sites. Assets (Increase) te Owner's Equity (Increase) Cash Design Revenues Debit Credit Debit Credit (+) q ) (+) 31 350,000 | 3-3 15,000 3-1 88,000 3-4 18,000 | 3-5 145,000 3-11 88,000 The transaction increased the asset—cash and increased the income account—design revenues. Asséts are increased by debits, income are increased by credits; hence, 2 debit of P88,000 to cash and a credit of P88,000 to design revenues is made. Increases in income increase owner's equity.—e The Accounting Equation and the Double Entry System | 2-25 Mar.16 Modesto paid P18,000 to MVP Bills Express for the semi-monthly utilities. Assets (Decrease) = ‘Owner's Equity (Decrease) Cash Utilities Expense Debit Credit Debit Credit (+) () (+) @) 3-1 350,000 | 3-3 15,000 3-16 18,000 34 18,000 | 3-5 145,000 3.41 88,000 | 3-16 18,000 Expenses are increased by debits and assets are decreased by credits; therefore, utilities expense is debited and cash credited for P18,000. Increases in expenses decrease owner's equity. Mar.17 Modesto billed clients P35,000 for services already rendered during the month. . Assets (Increase) ‘Owner’s Equity (Increase) Accounts Receivable Design Revenues Debit Credit * Debit Credit (+) 0 oO (4) 3-17 35,000 3-11 88,000 3-17 35,000 Assets are increased by debits, income are increased by credits. Increases in income increase owner's equity. A debit of P35,000 to accounts receivable and a credit of P35,000 to the ingome account—design revenues is needed. ‘ 4 Mar. 19 . Modesto partially paid P17,000 for the Mar. 9 purchase of computer supplies. Assets (Decrease) = Liabilities (Decrease) Cash Accounts Payable Debit Credit Debit Credit (+) 7 0) Q (+) 34 350,000 | 3-3 15,000 3.19 17,000 | 3-9 25,000 34 18,000 | 3-5 145,000 3-11 88,000 | 3-16 18,000 3.9 17,000 assets are decreased by credits while liabilities are decreased by debits. The transaction is recorded by debiting accounts payable and crediting cash for P17,000 each.i da 2:26 |_Basic Financial Accounting and Reporting 2022 Edition by Prof. WIN Balla‘ Mar. 20 Received checks totaling P25,000 from clients for billings dated Mar. 17. Assets (Increase) = bots Cee cash Accounts Receivable Debit Credit Debit oe ) 0 “ ° 3-1 350,000 | 3-3, 15,000 3-17 35,000 | 3-20 25,000 3-4 18,000 | 3-5 145,000 3-11 88,000 | 3-16 18,000 3-20 25,000 | 3-19 17,000 Collections on account reduced the asset—accounts receivable but increased the asset—cash. Assets are increased by debits and decreased by credits; thus, a debit to cash for P25,000 and a credit to accounts receivable for P25,000 is made. Mar. 21 Modesto withdrew P20,000 from the business for her personal use. Assets (Decrease) = Owner’s Equity (Decrease) Cash Modesto, Withdrawals Debit Credit + Debit Credit (+) oO () QO 34 350,000 | 3-3 15,000 321 20,000 34 18,000 | 3-5 145,000 341 88,000 | 3-16 18,000 3-20 25,000 | 3-19 17,000 324 20,000 Ig are reductions of owner's equity’but /are not expense® of the business entity. A withdrawal is a personal transaction of the owner that is exactly the opposite of an investment. This transaction increased the withdrawals account but reduced cash. Debits record increases in the withdrawals account and credits record decreases in asset accounts; thus, a debit to withdrawals and a credit to cash for P20,000 each is necessary. Mar. 27 Alessandra billed Modesto for P8,000 ads. Modesto will pay next month. Liabilities (Increase) 5 Owner's Equity (Decrease) Accounts Payable Advertising Expense Debit Credit Debit Credit 0 (+) (+) Q 3-19 17,000 | 3-9 25,000 3.27 8,000 m 3-27 8,000— The Accounting Equation and the Double Entry System | 2-27 This trai i + . Se increased the expense—advertising expense and increased the ae eer Payable by P8,000. Expenses are increased by debits while liabilities acco sed by credits; hence, an entry to debit advertising expense and to credit lunts payable for P8,000 is needed. Mar. 7 A . r-31 Modesto paid her assistant designer salaries of P15,000 for the month. Assets (Decrease) = Owner's Equity (Decrease) Cash Salaries Expense Debit Credit Debit Credit (+) 0 (+) 10) 3-1 350,000 | 3-3 15,000 3-31 15,000 3-4 18,000 | 3-5 145,000 3-11 88,000 | 3-16 18,000 3-20 25,000 | 3-19 17,000 3-21 20,000 3-31 15,000 Expenses are increased by debits and assets are decreased by credits. Hence, salaries expense is debited for P15,000 and cash credited for the same amount. Increases in salaries expense decrease owner's equity. DISTINCTION BETWEEN REVENUES AND RECEIPTS At this point, it will be useful to learn the distinction between revenues and receipts as illustrated in the following table. The table shows various types of sales transactions and classifies the effect of each on cash receipts and sales revenues for “this year”: This Year Transaction Amount Cash Sales Receipts Revenue 200,000 - P200,000 —-P200,000 1. Cash sales made this year. 300,000 300,000 0 2. Credit sales made last year; cash received this year. 3. Credit sales made this year; cash received this year. 4, Credit sales made this year; cash to be received next year. Total 400,000 400,000 400,000 100,000 0 100,000