Basic Financial Accounting & Reporting The Accounting Equation and the Double-Entry System Learning Objectives: : After studying this chapter, you should be able to: Describe the parts of an information system. Explain how an accounting information system helps the decision makers. Define the elements of financial statements. Describe the account (the simple T-Account) and its uses. 5. Understand what is meant by the accounting equation and prove the validity of the "mirror image" concept. 6, Understand what is meant by the double-entry system. 7. Explain how the ou led -entry system follows the rules of the accounting equation. 8. Define debits and credits. 9. Summarize the rules of debit and credit as applied to alarica? sheet and income statement accounts. 10. Describe the nature of the typical account titles used in recording transactions. 11. Analyze and state the effects of business transactions on an entity's assets, liabilities and owner's equity and record these effects in accounting equation form using the financial transaction worksheet and the T- Accounts. 12. Distinguish between revenue and receipts. AwNE Companies like Microsoft, the software giant and Deloitte & Touche, the big US accounting firm, use Vervex’s EnGage 2.0 to manage large projects that involve employees, subcontractors and Consultants worldwide. The software allows team members to report on their progress via the corporate intranet, as well as generate invoices and timesheets that can be easily accessed by corporate headquarters. Intranet is a version of the Intemet internal to a specific company and is privately controlled. Vervex Technologies established in 1994 is owned by Price Givens. This Irvine, California-based company develops database and corporate intranet applications that help project managers keep track of offsite workers’ projects. Givens and his team of software developers started by producing project management applications for accountants. But with Givens in Irvine and the64 | Basic Finencio y Prof. WIN Ballada pony’s software developers in Bellevue, Washington, geographic distance interfered with ollaboration. Givens knew an intranet could be the ultimate solution. Vervex’s newese nmekeeping sotware program, FSBTime, was designed specifically for accountants, architects and others who bill clients for their time. However, 27-year old Givens was surprised to find out that most visitors to Vervex’s Web site were actually other software companies. “One of our biggest customers has all their software developers in India and all their managers in California» Givens said. Givens was able to create a niche by addressing specific needs such that sales in 1996 was USS1.2 million. 1999 projections is USS2.5 million. Adopted from: Business Start-Ups, Apri 1993 Givens is helping business entities generate timely accounting information regarding activities or events which are important to the continued existence of the business. His software products ensure that his clients have the accurate and relevant data needed by the system to be able to accumulate the information necessary for timely accounting reports. PARTS OF AN INFORMATION SYSTEM An information system is a collection of people, procedures, software, hardware and data which works together to provide information essential to running an organization. espe, : ; People are competent end users working to increase their productivity. End users use hardware and software to solve information-related or decision-making problems. Procedures ' Procedures are manuals and guideli instruct end users on how'to use the software and hardware. are oftware Is another name for progra ructions that tell the computer how to process data. There are basically two kind System Software System software is ba resources. An example is ‘operating systems. e that helps a cor “manage nternal g system. Windows and Linux are popular Application Software Application software performs useful work on general-purpose problems. The two types of applications software are basic applications and advanced applications. asic applications include: + Erowsers—navigate, explore, find Information on the Internet. . Word processor —prepare written documents,The Accounting Equation and the Double Entry System | 65 OT ‘+ Spreadsheet—analyze and summarize numerical data. Database management system—-organize and manage data and information. «Presentation graphics—communicate a message or persuade other people. ‘Advanced applications include: Multimedia “integrate video, music, voice, and graphics to create interactive presentati Web publishers—create interactive multi-media Web pages. Graphics programs—create professional publications, draw, edit, and modify images. Virtual reality—create realistic three-dimensional virtual or simulated environments. ‘Antficial intelligence—simulated human thought processes and actions. Project managers—plan projects, schedule, people, and control resources. Hardware Hardware consists of input devices, the system unit, secondary storage, output devices, and communication devices. Input Devices 5! i Input devices translate data and programs that humans can understand into a form the computer can process. The more common are the keyboard, mouse, scanner, digital camera and microphone. “The System Unit The system unit consists of electronic circuitry with two parts: '* Central processing unit (CPU)—controls and manipulates data to produce information. + Memory (primary storage)—temporarily holds data, program instructions, and processed data. Secondary Storage Secondary storage stores data and programs. Three most common storage media are: flash drive, hard disk and optical disk. Output Devices Output devices output processed information from the CPU. Two important output devices are: monitor and printer. Communications Devices . These send and receive data and programs from one computer to another. A device that connects a microcomputer to a telephone is a modem. Data Data is the raw material for data processing. Data consists of numbers, letters and symbols and relates to facts, events and transactions. Data describes something and is typically stored electronically in a file. A file is a collection of characters organized as a single unit. Common types of files are: document, worksheet and database.66 | Basic Financial Accounting and Reporting 2021 Edition by Prof. WIN Balada SS ACCOUNTING INFORMATION SYSTEM. Every business organization must have an accounting information system which will generate reliable financial information needed by the decision-makers in a timely manner. The design and operation of a system must consider the anticipated users of the information and the types of decisions they are expected to make. The design of the system to meet the entity's information requirement depends on the firm’s size, nature of operations, volume of transaction data, organizational structure, form of business and extent of government regulation. These will influence the way in which information is accumulated and reported in the financial statements. An accounting information system is the combination of personnel, records and procedures that a business uses to meet its:need for financial information. Most firms have an accounting manual that specifies the policies and procedures to be followed in accumulating information within the accounting information system. , This manual details what events are to be recorded in the accounts, and when anid how the information is to be classified and accumulated. The ‘Accounting Process Economic ‘Accounting Activities Information Actions (decisions) Decision Makers ‘An effective accounting information system should achieve the following objectives: ‘+ To process the information efficiently at the least cost (cost-benefit principle). * To protect entity’s assets, to ensure that data are reliable, and to minimize wastes and the possibility of theft or fraud (control principle). To be in harmony with the entity's organizational and human factors (compatibility principle). . * To be able to accommodate growth in the volume of transactions arid for organizational, changes (flexibility principle).+ The Accounting Equation and the Double Entry System | 67 ‘The preceding diagram illustrates how economic activities flow into the accounting process, which produces accounting information. This information is then used by decision makers in making economic decisions and taking specific actions; thus, resulting in economic activities. The cycle goes on. TYPES OF ACCOUNTING INFORMATION SYSTEMS In general terms, companies use three types of accounting information systems to record the results of transactions: manual systems, computer-based transaction systems and database systems. All of these systems are designed to capture information regarding accounting events to prepare financial statements. In a nutshell, manual systems utilize paper-based journals (general and special) and ledgers (general and subsidiary). Computer-based transaction systems replace paper records with computer records. Database systems embed accounting data within the business event data on which they are based. . Computer-Based Transaction Systems Manual systems rely on human processing so they are labor intensive and may be Jnefficient in today’s complex business environment. Because manual systems rely on human processing, they may be prone to error. To overcome these deficiencies, many companies have computerized their accounting processes. A computer-based transaction system mairitains accounting data separately from other operating data. That is, the accounting records are kept separately from the records required for the expenditure, revenue and conversion processes. Suffice it to say, at this point, that there is a greater degree of compartmentalization of work to preserve the integrity of the accounting information system but not as ideal as the database system. This system treats information in the same manner as a manual system. The user is simply filling in a computer screen that looks and oftentimes acts like a source document. Some of the advaritages of this system are as follows: * Transactions can be quickly posted to the appropriate accounts, bypassing the journalizing process. ‘* Detailed listings of transactions can be printed for review at any time, © Internal controls and edit checks can be used to prevent and detect errors. © Awide variety of reports can be prepared, Accounting packages consists of several modules. A module is ‘a program which deals. with one particular part of a business accounting system. A simple accounting package might consist of only one module, in which case it is called a stand-alone module. But more often it will consist of several modules, in which case, it will then be called a suite. Examples include QuickBooks and Peachtree.68 | Basic Financial Accounting and Reporting 2021 Edition by Prof. WIN Ballada Se Database Systems Relational database systems such as enterprise resource planning (ERP) depart from the “accounting equation” method of organizing data. These ERP systems such as SAP, Oracle and PeopleSoft capture data, both financial and non-financial, and store that information in a data warehouse. Database systems reduce inefficiencies and redundancies that often exist in transaction-based systems. For example, in transaction-based systems, customer information (like name, address, phone, credit limit) is often maintained separately from customer account information. Thus, a salesperson who does not know a customer's balance might inadvertently encourage a customer to purchase items that exceed that credit limit. Also, separate departments have special information needs such that when a database system is not used then the same customer information may be recorded several times. ‘Advantages of database systems include: ‘© The system recognizes business rather than just accounting events. * The system supports reduction in operating inefficiencies. © The system eliminates redundant data. STAGES OF DATA PROCESSING Processing of raw data into useful accounting information then finally into summarized reports follows the usual input-processing-output progression. Each transaction entered into the accounting system should be supported by source documents like customer invoices, vendor invoices, deposit slips, checks, timecards and memos. These documents serve as evidence that a particular transaction occurred. They also provide the necessary details and supports. The computer, with the use of the accounting software, then processes the inputs. As will be discussed later, the manual system of journalizing, posting, preparing the trial balance and updating the accounts are done almost instantaneously. When required, the financial statements and other accounting reports can be viewed on the screen or printed as output documents. In many situations, manual systems are inferior to computerized systems in terms of productivity, speed, accessibility, quality of output, incidence of errors and bulk. ELEMENTS OF FINANCIAL STATEMENTS The elements of financial statements defined in the March 2018 Conceptual Framework for Financial Reporting (2018 Conceptual Framework) are: . ilities and equity - relate to a reporting entity's financial position; and . incomeand eters relate to a reporting entity's financial performance.The Accounting Equation and the Double Entry System | 69 In summary, the elements of financial statements are defined as follows: * [L Blement Definition or Description ‘Asset | Avpresent economic resource controlled by the entity as 9 result of past events, An economic resource is a right that has the potential to produce economic benefits. Liability | Apresent obligation of the entity to transfer an economic resource as a result of ast events, ' Equity | The residual interest in the assets of the entity after deducting allits liabilities, Income | Increases in assets, or decreases in abilities, that result in increases in equity, ther than those relating to contributions from holders of equity claims. Expenses | Decreasesin assets, or increases in iabilties, that result in decreases in equity, other than those relating to distributions to holders of equity claims. Financial Position alia Per March 2018 Conceptual Framework for Financial Reporti Framework), Fe eS encecmnor resource controllec _past events. An economic resource is a right that has the potential to produce economit benefits. There are three aspects to these definitions: “right”; “potential to produce economic benefits”; and “control”. ptual Rights that have the potential to produce economic benefits take many forms, including: (a) rights that correspond to an obligation of another party, for example: (i) rights to receive cash. (ii) rights to receive goods or services. (iii) rights to exchange economic resources with another party on favorable terms. Such rights include, for example, a forward contract to buy an econor resource on terms that are currently favorable or an option to buy an economic resource, , (iv) rights to benefit from an obligation of another party to transfer an economic resource if a specified uncertain future event occurs, (b) rights that do not correspond to an obligation of another party, for example: (i) rights over physical objects, such as property, plant and equipment or inventories. Examples of such rights. are a right to use a physical object or 2 right to benefit from the residual value of a leased object (ii) rights to use intellectual property, An economic resource could produce economic benefits for an entity by entitling or enabling it to do, for example, one or more of the followin (a) receive contractual cash flows or.another economic resource; (b) exchange economic resources with another party on favorable terms;70 | Basic Financial Accounting and Reporting 2021 Edition by Prof. WIN Ballada ——————_———————— TY (c) produce cash inflows or avoid cash outflows by, for example: (i) using the economic resource either individually or in combination with other economic resources to produce goods or provide services; (ii) using the economic resource to enhance the Value of other economic resources; or (iii) leasing the economic resource to anothet party; (d) receive cash or other economic resources by selling the economic resource; or (e) extinguish liabilities by transferring the economic resource. An entity controls an economic resource if it has the present ability to direct the use of the economic resource and obtain the economic benefits that may flow from it. Control includes the present ability to prevent other parties from directing the use of the economic resource and from obtaining the economic benefits that may flow from it. It follows that, if one party controls an economic resource, no other party controls that resource, Liability A liability is a present obligation of the entity to transfer an economic resource as a result of past events. For aliability to exist, three criteria must all be satisfied: (a) the entity has an obligation; (b) the obligation is to transfer an economic resource; and (c) the obligation is a present obligation that exists as a result of past events An obligation is a duty or responsibility that an entity has no practical ability to avoid. An obligation is always owed to another party (or parties). The other party (or parties) could be a person or another entity, a group of people or other entities, or society at large. It is not necessary to know the identity of the party (or parties) to whom the obligation is owed. If one party has an obligation to transfer an economic: » resource, it follows that another party (or parties) has a right to receive that economic resource. Obligations to transfer an economic resource include, for example: (a) obligations to pay cash. ' (b) obligations to deliver goods or provide services. (c) obligations to exchange economic resources with another party on unfavorable terms. Such obligations include, for example, a forward contract to sell an economic resource on terms that are currently unfavorable or an option that entitles another party to buy an economic resource from the entity. (d) obligations to transfer an economic resource if a specified uncertain future event occurs, "The Accounting Equation and the Double Entry System | 71 (e) obligations to issue a financial instrument if that financial instrument will oblige the entity to transfer an economic resource. A present obligation exists as a result of past events only if: (a) the entity has already obtained economic benefits or taken an action; and (b)'as a consequence, the entity will or may have to transfer an economic resource that it would not otherwise have had to transfer. Equity Equity is the residual interest in the assets of the enterprise after deducting all its liabilities, In other words, they are claims against the entity that do not meet the definition of a'liability. Equity may pertain to any of the following depending on the form of business organization: : + Ina sole proprietorship, there is only one owner's equity account because there is only one owner. + Inapartnership, an owner's equity account exists for each partner. + In a corporation, owners’ equity or stockholders’ equity consists of share capital, retained earnings and reserves representing appropriations of retained earnings among others. Financial Performance Income is increases in assets, or decreases iri liabilities, that result in increases in equity, other than those relating to contributions from holders of equity claims. Expenses are decreases in assets, or increases in liabilities, that result in decreases in equity, other than those relating to distributions to holders of equity claims. It follows from these definitions of income and expenses that contributions from holders of equity claims are not income, and distributions to holders of equity claims are not expenses. Income and expenses are the elements of financial statements that relate to an entity's financial performance. Users of financial statements need information about both an entity's financial position and its financial performance. Hence, although income and expenses are defined in terms of changes in assets and liabilities, information about income and expenses is just as important as information about assets and liabilities, THE ACCOUNT A The basic summary device of accounting is the account. A separate account is maintained for each element that appears in the balance sheet (assets, liabilities and| 2021 Edition by Prof. WIN Ballada ee »me and expenses). Thus, an account may be ases, decreases and balance of each element 2ments. The simplest form of the account is 3 similarity to the letter "T". The account has sount Title or Right side or fe Credit side iness is performing. They are the final products of we arrive at the items and amounts that make UP rasic tool of accounting is the accounting equation. reces controlled by the enterprise, the present residual.interest in the assets. It states that assets ler’s equity. The basic accounting model is: Liabilities + Owner’s Equity ft side of the equation opposite the liabilities and ncreases and decreases in assets are recorded in the as liabilities and owner’s equity are recorded. The 2s and owner’s equity follow the same rules of debit : is related to the.accounting equation. Transactions es (left and right sides), subtractions from both sides n and subtraction on the same side (left or right side), .e maintained as shown below: Owner's Liabilities ' EauityThe Accounting Equation and the Double Entry System | 73 —— DEBITS AND CREDITS—THE DOUBLE-ENTRY SYSTEM Accounting is based on a double-entry system which means that the dual effects of a business transaction is recorded. A debit side entry must have a corresponding credit side entry. For every transaction, there must be one or more accounts debited and one or more accounts credited. Each transaction affects at least two accounts. The total debits for a transaction must always equal the total credits. An account is debited when an amount is entered on the left side of the account and credited when an amount is entered on the right side. The abbreviations for debit and credit are Dr. (from the Latin debere) and Cr. (from the Latin credere), respectively. The account type determines how increases or decreases in it are recorded. Increases in assets are recorded as debits (on the left side of the account) while decreases in assets are recorded as credits (on the right side). Conversely, increases in liabilities and owner's equity are recorded by credits and decreases are entered as debits. The rules of debit and credit for income and expense accounts are based on the relationship of these accounts to owner’s equity. Income increases owner's equity and expense decreases owner’s equity. Hence, increases in income are recorded as credits and decreases as debits. Increases in expenses are recorded. as debits and decreases as credits. These are the rules of debit and credit. The following summarizes the rules: Balance Sheet Accounts Assets Liabilities and Owner's Equity Debit . pce ve Credit Increases ect reese Increases, Normal Balance Normal Balance Income Statement Accounts ‘ Debit for decreases in owner's equity Credit for increases in owner's equity Expenses Income Debit rT a Credit t ta dad hf au t Increases actlees nares Increases Normal Balonce Normal Balance74 | Basie Financial Accounting and Reporting 2021 Edition by Prof. WIN Ballada Accounts Debit Credit Increases in Increases in t Assets Liabilities t Expenses Owner's Capital Income Decreases in Owner's Capital Assets Liabilities | J Decreases in Income Expenses NORMAL BALANCE OF AN ACCOUNT The normal balance of any account refers to the side of the account—debit or credit— where increases are recorded, Asset, owner's withdrawal and expense accounts normally have debit balances; liability, owner's equity and income accounts normally have credit balances. This result occurs because increases in an account are usually greater than or equal to decreases. Increases Recorded by Normal Balance ‘Account Category - Debit Credit Debit Credit Assets v v Liabilities v v ‘Owner's Equit ‘Owner's Capital v v Withdrawals v v Income v v Expenses v v ACCOUNTING EVENTS AND TRANSACTIONS An accounting event is an economic occurrence that causes changes in’an enterprise’s assets, liabilities, and/or equity. Events may be internal actions, such ‘as the use of equipment for the production of goods or services. It can also be an external event, such as the purchase of raw materials from a supplier. A transaction is a particular kind of event that involves the transfer of something of value between two entities. Examples of transactions include acquiring assets from owner(s), borrowing funds from creditors, and purchasing or selling goods and services. TYPES AND EFFECTS OF TRANSACTIONS It will be beneficial in the long-term to be able to understand a classification approach t emphasizes the effects of accounting events rather than the recording procedures t involved. This approach is quite pioneering. Although business entities merous transactions, all transactions can be classified into one of four,The Accounting Equation and the Double Entry System | 75 —————$—— 1. Source of Assets (SA). An asset account increases and a corresponding claims (liabilities or owner's equity) account increases. Examples: (1) Purchase of supplies ‘on account; (2) Sold goods an cash on delivery basi 2. Exchange of Assets (EA). One asset account increases and another asset account decreases. Example: Acquired equipment for cash. Use of Assets (UA). An asset account decreases and a corresponding claims (liabilities or equity) account decreases. Example: (1) Settled accounts payable; (2) Paid salaries of employees. 4, Exchange of Claims (EC). One claims (liabilities or owner’s equity) account increases and another claims (liabilities or owner's equity) account decreases. Example: Received utilities bill but did not pay. Every accountable event has a dual but self-balancing effect on the accounting equation. Recognizing these events will not in any manner affect the equality of the basic accounting model. The four types of transactions above may be further expanded into nine types of effects as follows: a 1. Increase in Assets = Increase in Liabilities (SA) 2. Increase in Assets = Increase in Owner’s Equity (SA) 3, _ Increase in one Asset = Decrease in another Asset (EA) A. Decrease in Assets = Decrease in Liabilities (UA) 5, " Decrease in Assets = Decrease in Owner’s Equity (UA) 6. _ Increase in Liabilities = Decrease in Owner's Equity (EC) 7. Increase in Owner's Equity = Decrease in Liabilities (EC) 8. _ Increase in one Liability = Decrease in another Liability (EC) 9. Increase in one Owner's Equity = Decrease in another Owner's Equity (EC) TYPICAL ACCOUNT TITLES USED . STATEMENT OF FINANCIAL POSITION Assets Assets are should be classified only into two: current assets and non-current assets. Per revised Philippine Accounting Standards (PAS) No. 1, an entity shall classify assets as current when: 2. It expects to realize the asset, or intends to sell or consume .it, in its normal operating cycle; : b. it holds the asset primarily for the purpose of trading; c. it expects to realize the asset within twelve months after the reporting period; or d. the asset is cash or a cash equivalent (as defined in PAS No. 7) unless the asset is restricted from being exchanged or used to settle a liability for at least twelve months after the reporting period. All other assets should be classified as non-current assets. Operating cycle is the time between the acquisition of assets for processing and their realization in cash or cash equivalents. When the entity's normal operating cycle is not clearly identifiable, it is assumed to be twelve months. i :ncial Accounting and Reporting 2021 Edition by Prof. WIN Ballada Current Assets Cash. Cash is any medium of exchange that a bank will accept for deposit at face value, It includes coins, currency, checks, money orders, bank deposits and drafts. Cash Equivalents. Per PAS No. 7, these are short-term, highly liquid investments that are readily convertible to known amounts of cash and’ which are subject to an insignificant risk of changes in value. ; Notes Receivable. A note receivable is a written pledge that the customer will pay the business a fixed amount of money on a certain date. Accounts Receivable. These are claims against customers arising from sale of services or goods on credit. This type of receivable offers less security than a promissory note. Inventories. Per PAS No. 2, these are assets which are (a) held for sale in the ordinary | course of business; (b) in the process of production for such sale; or (c) in the form of materials or supplies to be consumed in the production process or in the rendering of | services. Prepaid Expenses. These are 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. These prepaid items represent’ future economic benefits—assets—until the time these start to contribute to the earning process; these, then, become éxpenses. Non-current Assets Property, Plant and Equipment. Per PAS No. 16, these are tangible assets that-are held | by an enterprise for use in the production or supply of goods or’services, or for rental to | others, or for administrative purposes and which are expected to be used during more than one period. Included are such items as land, building, machinery and equipment, furniture and fixtures, motor vehicles and equipment. Accumulated Depreciation. It is a contra account that contains the sum of the periodic | depreciation charges. The balance in this account is deducted from the cost of the related asset—equipment or buildings—to obtain book value. Intangible Assets. Per PAS No. 38, these are identifiable, nonmonetary assets without physical substance held for use in the production or supply of goods or services, for | rental to others, or for administrative purposes.. These include goodwill, patents, copyrights, licenses, franchises, trademarks, brand names, secret processes: | subscription lists and non-competition agreements.Liabil Per revised Philippine Accounting Standards (PAS) No. 1, an entity shall classify a liability as current when: it expects to settle the liability in its normal operating cycle; it holds the liability primarily for the purpose of trading; the liability is due'to be settled within twelve months after the reporting period; or the entity does not have an unconditional right to defer settlement of the liability for at least twelve rrionthé after the reporting period. pose Allother liabilities should be classified as non-current liabilities. Current Liabilities 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. * Notes Payable. A note payable is like a note receivable but in a reverse sense. In the case of a note payable, 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. 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 or services, the amounts received are recorded in the unearned revenue account (liability method).- When the goods or services are provided to the customer, the unearned revenue is reduced and income is recognized. Current Portion of Long-Term Debt. These are portions of mortgage notes, bonds and other long-term indebtedness which are to be paid within one year from the balance Sheet date. Non-current Liabilities Mortgage Payable. This account records long-term debt’ of the business entity for which the business entity has pledged certain assets as security to the creditor. In the event that the debt payments are not made, the creditor can foreclose or cause the mortgaged asset to be sold to enable the entity to settle the claim. Bonds Payable. Business organizations often obtain substantial sums of money from lenders to finance the acquisition of equipment and cther needed assets. They obtain these funds by issuing bonds. The bond is a contract between the issuer and the lender specify ing the terms of repayment and the interest to be charged. -Owner's Equity Capital (from the Latin capitalis, meaning “property”). 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 profit earned during the year or is decreased by a loss. Cash or other assets that the owner may withdraw from the business ultimately reduce it, . 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 isa temporary account used at the end of the accounting period to close income and expenses. This account shows the profit or loss for the period before closing to the capital account. : INCOME STATEMENT Income Service Income, Revenues earned by performing services for a customer or client; for example, accounting services by a CPA firm, laundry services by a laundry shop. Sales, Revenues earned as a result of sale of merchandise; for example, sale of building materials by a construction supplies firm. Expenses Cost of Sales. The cost incurred to purchase or to produce the products sold to customers during the period; also called cost of goods sold. Salaries or Wages Expense. Includes all payments as a result of an employer-employee relationship such as salaries or wages, 13° month pay, cost of living allowances and other related benefits, Telecommunications, Electricity, Fuel and Water Expenses. Expenses related to use of telecommunications facilities, consumption of electricity, fuel and water. Rent Expense. Expense for space, equipment or other asset rentals, Supplies Expense. Expense of using supplies (e.g. office supplies) in the conduct of daily business. Insurance Expense. Portion of premiums paid on insurance coverage {e.g. on motor vehicle, health, life, fire, typhoon or flood) which has expired.The Accounting Equation and the Double Entry System | 79 5 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 coi:dition 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 ‘tenet 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 responsibility. Any 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 2020, 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.iti llada 80 | Basic Financial Accounting and Reporting 2021 Edition by Prof. WIN Balla Modesto Graphics Design Financial Transaction Worksheet Month of March 2020 Assets 2 Liabilities + Owner's Equity 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 in the business entity. The source of this asset is the contribution made by the owner, which represents owner's equity. The owner's equity account 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. «At this point, the entity has no liabilities, and assets equal owner's equity. Mar.5 Computer equipment costing P145,000.is acquired on cash basis. The effect of the transaction on the basic equation is: Assets = Liabilities + Owner's Equity Cash + Computer = Modesto, Capital Equipment Bal. 350,000 = 350,000 (5) _ (145,000) P145,000 Bal. + 145,000 350,000 350,000 = 350,000 This transaction did not change the total assets but it did ch: assets—it decreased one asset—cash and increased another asset—computer equipment by P145,000. Note that the sums of the balances on both sides of the equation are equal. This equality must always exist, ange the composition of the Mar.9 Computer supplies in the amount of P25,000 are purchased on account. Assets = Liabil les + Owner's Equity " Cash + Computer + Computer Accounts + ~— Modesto, Capital Supplies Equipment Payable Bal. 205,000 P145,000 = 350,000 (9) : 25,000 = P 25,000 Bal, __P205,000 + _P25,000 + __P145,000~ = P 25,000 + 350,000 375,000 = 375,000 aoe —_The Accounting Equation and the Double Entry System | 81 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 on account. 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 = Liabilities + Owner's Equity Cash + Computer + Computer = Accounts +" - Modesto, Supplies Equipment Payable Capital Bal. 205,000 25,000 145,000 = 25,000 350,000 (11) __ 88,000 = : 88,000 Bal, _ 293,000 + _P25,000 + __P145,000_ = P25,000_ + 438,000) 453,000. = 463,000 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 P'18,000 to MVP Bills Express, a one-stop bills payment service company, for the semi-monthly utilities. Assets Liabilities + ~ Owner's Equity Cash + Computer ¥ Computer Accounts + ~—‘ Modesto, Capital Supplies Equipment Payable Bal. 293,000 25,000 145,000 = 25,000 438,000 (a6) ___ (18,000) = (18,000) Bal, __P275,000_ + _P25,000_ + 145000 = P25;000_ + 420,000 445,000 445,000 Expenses are 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 ahd 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 théir web sites weekly. Modesto billed these clients P35,000 for services already rendered during the month.82 | Bosic Financial Accounting and Reporting 2021 Edition by Prof. WIN Ballada ——_——_——— oF A Lo + On Cash # © Accounts + Computer + Computer ‘Accounts + Modesto, Receivatle Supplies Equipment Payable Capital’ Bal. 275,000 25,000 145,000 = 25,000 420,000, a7) “P35,000 = 35,000 a Bal. _P275,000_ + __P35,000_ + 25,000 + P145,000 P25,000_ + __PA55,000 480,000 = _P480,000 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 25,000 145,000 25,000 455,000 (19) __ (27,000) (17,000)_ Bal. = P258,000_ + P35,000_ + 25,000 + 145,000 = __P8,000 + P455,000_ | 463,000 463,000, This transaction is a payment on account. The effect on the accounting equation is @ | 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 al rai + OE Cash + += Aecounts_ «+ ©Computer + Computer = Accounts + Modesto, Receivable Supplies * Equipment Payable Capital Bal. 258,000 35,000 25,000 145,000 = ~ P8,000 455,000 (20) 25,000 (25,000) . Bal. 283,000 + P10,000_ + P25,000_ + P145,000_ = P8,000. + ee 463,000 = ° P463,000Accounting Equation and the Double Entry System | 83 tty ans ene billed clients for services already rendered, On Mar. 20, the Collect P25,000 from Bae The business should them. The asset—cash is increased by P25,000. Not record service income on Mar. 20 sinc income last Mi 2 it has already recorded the Income last Mar. 17. Total assets are unchanged. The business merely reduced one asset—accounts receivable and increased anather—cash, Mar. 21 Modesto withdrew 20,000 from the business for her personal use. A di + OE Cash + Accounts. + Computer + Computer Receivable ‘Supplies Accounts + Modesto, Equipment Payable Capital Bal. 283,000 10,000, “p25,000 145,000 = —P8,000 455,000 (24) __{20,000) = (20,000) Bal. _P765,000_ + 10,000. + _P25,000_ + __P145000 = _ 8,000 + __P435,000_ 443,000. = 443,000 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 350,000; 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 toa 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 = ak + OE Cash + Accounts + Computer + Computer = Accounts + Modesto, Receivable Supplies Equipment Payable Capital Bal. 263,000 P10,000 25,000 145,000 P 8,000 435,000 (27) 8,000 (3,000) Bal, _ 263,000, 30,000. +___P25,000 145,000 P16,000_ + __P427,000 443,000 = __P443,000 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 ‘equity and an increase in'the liability—accounts payable.and Reporting 121 Edition by Prof. WIN Ballada Mar. 31 Modesto paid her assistant designer salaries of P15,000 for the month. A Z = L + OE cash + Accounts + Computer + Computer Accounts + Modesto, Receivable Supplies Equipment Payable Capital Bal 10,000 25,000, P145o00 = —P16,000 427,009, (28) __(15,000) a = (35,000) Sol. P288,000_ + —P10,000_ + P2500 +” _P145,000_ = _ _Pi6,000 + P412,000 a + FS 000 = 6,000 + EN, 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. i Illustration. 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 BPI Poblacion Branch. Assets (Increase) = Owner's Equity (Increase) Cash Modesto, Capital Debit Credit > Debit Credit (+) 0 0 (+) 3-1 350,000 3 350,000 This transaction increased both the asset—cash and owner's equity. According to. the rules of debit and credit, an increase in asset is recorded as debit while a owner's equity is recorded as credit; thus, the entry is to debit ‘Modesto, Capital. The transaction dates are placed on the left side reference.The Accounting Equation and the Double Entry System | 85 Mar.2 Computer equipment is acquired by issuing a PS0,000 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 oO (+ 3-2 50,000 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) . Assets (Increase) Cash Prepaid Rent Debit Credit Debit Credit ) a i) Q 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 4 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) = Liabilities (Increase) Cash + Unearned Revenues Debit Credit Debit _ Credit (+) 0 +) (+) 34 350,000 | 3-3 “15,000 a4 18,000 3-4 18,000 The entity has an obligation to Marco Polo ASEAN Hotel for the next three months. This Jiability is called unearned revenues. The asset—cash is increased by a debit of P18,000 ind the liability—unearned revenues is increased by a credit of P18,000. As it renders ervice, the entity discharges its obligation at a rate of P6,000 per month for the next86 | Basic Financial Accounting and Reporting 2021 Edition by Prof. WIN Ballada cn ne Mar.5 Computer equipment costing P145,000 is acquired on cash basis. Assets (Decrease) = Assets (Increase) Cash Computer Equipment Debit Credit Debit Credit ) a «) 0 BL 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 0 () 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) = Owner's Equity (Increase) Cash Design Revenues Debit Credit Debit Credit (*) @ i] (4) 21 350,000 | 3-3 15,000 341 88,000 24 18,000 | 3-5 145,000 4 241 88,000 The transaction increased the asset—cash and increased the income account—desigt revenues. Assets are increased by debits, income are increased by credits; henc® a debit of P88,000 to cash and a credit of P88,000 to design revenues is rnade. Increase in income increase owner's equity.The Accounting Equation and the Double Entry System | 87 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 y Q (+) 0 3-4 350,000 | 33 15,000 18,000 34 18,000 | 3-5 145,000 3-11 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 i) Q a @) 317 35,000 Bat 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 35,000 to the income account—design revenues is needed. 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 ~ () 0 oO a) 34 350,000 | 3-3 15,000 17,000 | 3-9 25,000 3-4 18,000 | 3-5 145,000 3-41 88,000 | 3-16 18,000 3.19 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 P'17,000 each88 | Basic Financial Accounting and Reporting 2021 Edition by Prof. WIN Ballada Mar. 20 Received checks totaling P25,000 from clients for billings dated Mar. 17, Assets (Increase) = Assets (Decrease) Cash Accounts Receivable Debit Credit Debit * Credit @) 0 ) 0 31 350,000 | 3.3 15,000 347 35,000] 3-20 25,000 34 18,000 | 3-5 145,000 * 341 88,000] 3.16 18,000 320 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 (+) 0 ( 0 3-1 350,000 | 3-3 15,000 3-21 20,000 3-8 18,000 | 3-5 * 145,000 Bed 88,000 | 3-16 18,000 3-20 . 25,000| 3-19 17,000 3-21 20,000 : Withdrawals are reductions. of owner's equity but are not expenses 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 witl pay next month. Liabilities (Increase) = Owner's Equity (Decrease) Accounts Payable Advertising Expense Debit Credit Debit Credit 0 (+) (+) 4 0 3-19 17,000 | 3-9 25,000 3-27 8,000 3-27 8,000The Accounting Equation and the Double Entry System | 89 Ei ee leila it ae alin This transaction increased the expense—advertising expense and increased the liability—accounts payable by P8,000. Expenses are increased by debits while liabilities are increased by credits; hence, an entry to debit advertising expense and to credit accounts payable for P8,000isneeded. _ , Mar, 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 (+) D) (+) tP) 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 . 331 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”: ThisYear Transaction Amount Cash Sales : J Receipts Revenue 1. Cash sales made this year. 200,000 200,000 200,000 2. Credit sales made last year; 300,000 300,000 0 cash received this year. 3. Credit sales made this year; 400,000. 400,000: 400,000 cash received this year. 4. Credit sales made this year; 100,000 0 * 100,000 cash to be received next year. es Total 900,000 ___P700,000