UNIT 3: ANALYSES OF BUSINESS TRANSACTION

UNIT 3: ANALYSES OF BUSINESS TRANSACTION

At the end of the unit, the students must have:
1. Identified the essence of the double entry system of accounting;
2. Explained the accounting equation;
3. Described the rules of debit and credit;
4. Determined the normal balance of accounts;
5. Analyzed the effects of business transactions on the elements of the financial statements
and the accounting equation.
DOUBLE-ENTRY ACCOUNTING AND ACCOUNTING SYSTEMS
Imagine an entity that does not maintain records of their business transactions. Imagine
also that this organization has voluminous transactions in a month or in a year. How will they know
the health of the entity? How will they know if they earn a profit or not? Will they look at the sky
and count the stars? Will the organization provide a reliable information? Think about it.
All forms of organizations need to have an organized files of all the source documents and
financial records of its business transactions. Particularly those transactions that cause changes
in the accounting elements of the entity. Those transaction be properly recorded and accounted
for through the use of a well-defined bookkeeping system.
The double entry accounting system recognizes the concept of duality and equilibrium.
The concept of duality points that in every transaction recorded, at least two accounts are affected.
There must be at least one debit and one credit. On the other hand, the concept of equilibrium
requires the equality of debits and credits for each transaction recorded in the books of accounts.
There are two sets of books accounts. The journal and the ledger.
The journal is used to initially record the transactions in chronological order. Hence, it is
also called as the book of original entry. There are two kinds of a journal, the general journal and
the special journal. But the most basic form of a journal is the general journal.
GENERAL JOURNAL
A general journal shows all the effects of a transaction in terms of debits and credits. The
general journal has five columns: date column, particulars column, folio or posting reference
column (abbreviated as “F” or “P.R.”), debit column and credit column.
Illustration 3-1 illustrates the format of a general journal.

Illustration 3-1 General Journal

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The ledger is a collection of the entire group of accounts. All transactions recorded in the
journal are transferred in the ledger for final recording. This why it is also called as the book final
entry. There are also two kinds of a ledger, the general ledger and the subsidiary ledger.
RULES OF DEBIT AND CREDIT, AND NORMAL BALANCES OF AN ACCOUNT
In the previous chapter, you have learned how to analyze transactions. Through the use
of the accounting equation, you were able to analyze the effects of a transaction whether it will
increase or decrease any of the accounting elements.
Let take a look again at the basic accounting equation:
Assets = Liabilities + Owner’s Equity
Haven’t you wondered why the accounting equation is written that way? Mathematically,
the accounting equation can also be written as follows:
 Assets - Liabilities = Owner’s Equity
 Assets – Owner’s Equity = Liabilities
 Liabilities +Owner’s Equity = Assets
But why is asset written on the left side of the equation, and why liabilities and owner’s
equity are written on the right side of the accounting equation? This is to help us remember the
rules of debits and credits.
Rules of debits and credits
 Increase in assets are recorded as debits
 Decreases in assets are recorded as credits
 Increase in liabilities are recorded as credits
 Decreases in liabilities are recorded as debits
 Increases in owner’s equity are recoded as credits
 Decreases in owner’s equity are recorded as debits
Specific rules for accounts affecting the owner’s equity
 Increases in drawings are recorded as debits
 Decreases in drawings are recorded as credits.
 Increases in expenses are recorded as debits
 Decreases in expenses are recorded as credits.
 Increases in capital are recorded as credits
 Decreases in capital are recorded as debits
 Increases in income are recorded as credits
 Decreases in income are recorded as debits
Let’s take a look again at the expanded accounting equation:

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Note that drawings and expenses decreases owner’s equity. This is the reason why its
rules for debits and credits is on the opposite way. While capital and income increases owner’s
equity, we apply the same rules with owner’s equity.
Notice also that assets are written on the left side of the accounting equation. Drawings
and expenses have a negative sign when placed on the right side of the accounting equation.
But if the two accounts are transposed to the left side of the equation, mathematically, it
becomes positive. Debit on the other is the left side of the account. Thus, the normal balance of
assets, drawing, and expenses is debit.
Another observation, liabilities, capital, and income are placed on the right side of the
equation. Credit is also the right side of the account. This makes credit as the normal balance of
liabilities, capital, and income.
The normal balance of an account is its usual balance and is the side (debit or credit)
that increases the account.
Illustration 3-2 shows a summary for the rules of debits and credits, and the normal balances of
the major accounts.

Illustration 3-2 Rules of Debits and Credits

ANALYSIS OF BUSINESS TRANSACTION

The accounting process starts with the analysis of business transactions. A business transaction
is any financial event that changes the resources of a firm. For example, purchase, sale, payments,
and receipts of cash are all business transactions. The accountant analyzes each business
transaction to decide what information to record and where to record it.

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Beginning with Analysis

Let’s analyze the transactions of Wells’ Consulting Services, a firm that provides a wide range of
accounting and consulting services. Carolyn Wells, CPA, has a master’s degree in accounting. She
is the sole proprietor of Wells’ Consulting Services. Carlos Valdez, the office manager, has an
associate’s degree in business and has taken 12 semester hours of accounting. The firm is located
in a large office complex. Every month, Wells’ Consulting Services bills clients for the accounting
and consulting services provided that month. Customers can also pay in cash when the services
are rendered.
STARTING A BUSINESS
Let’s start from the beginning. Carolyn Wells obtained the funds to start the business by
withdrawing P2,000,000 from her personal savings account. The first transaction of the new
business was opening a checking account in the name of Wells’ Consulting Services. The separate
bank account helps Wells keep her financial interest in the business separate from her personal
funds.
When a business transaction occurs, it is analyzed to identify how it affects the equation property
equals financial interest. This equation reflects the fact that in a free enterprise system, all property
is owned by someone. In this case, Wells owns the business because she supplied the property
(cash).
Use these steps to analyze the effect of a business transaction:
1. Describe the financial event.
• Identify the property.
• Identify who owns the property.
• Determine the amount of increase or decrease.
2. Make sure the accounting equation is in balance.
Accountants use special accounting terms when they refer to property and financial interests.
Accountants use special accounting terms when they refer to property and financial interests. For
example, they refer to the property that a business owns as assets and to the debts or obligations
of the business as liabilities. The owner’s financial interest is called owner’s equity.
Property = Financial Interest

BUSINESS TRANSACTION
1. Investment of Cash as Capital
On September 1, 2021, Carolyn Wells withdrew P2,000,000 from personal savings and
deposited it in a new checking account in the name of Wells’ Consulting Services.
ANALYSIS
a. The business received P2,000,000 of property in the form of cash.
a. Wells had a P2,000,000 financial interest in the business.
Note that the equation property equals financial interest remains in balance. The total of one side
of the equation must always equal the total of the other side.

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An owner’s financial interest in the business is called or Carolyn Wells has P2,000,000 equity in
Wells’ Consulting Services.
2. Purchase of Equipment through cash payment
The first priority for office manager Carlos Valdez was to get the business ready for opening
day on December 1. Wells’ Consulting Services issued a P100,000 check to purchase a
computer and other equipment on September 3, 2021.
ANALYSIS
b. The firm purchased new property (equipment) for P100,000.
b. The firm paid out P100,000 in cash.
The equation remains in balance.

Notice that there is a change in the composition of the firm’s property. Now the firm has cash and
equipment. The equation shows that the total value of the property remains the same, P2,000,000.
Carolyn Wells’ financial interest, or equity, is also unchanged. Note that property (Cash and
Equipment) is equal to financial interest (Carolyn Wells, Capital).
These activities are recorded for the business entity Wells’ Consulting Services. Carolyn Wells’
personal assets, such as her personal bank account, house, furniture, and automobile, are kept
separate from the property of the firm. Nonbusiness property is not included in the accounting
records of the business entity.
3. Purchase of Equipment on Credit
On September 10, 2021, Office Plus, the store selling the equipment, allows Wells’
Consulting Services 60 days to pay the bill worth P155,000. This arrangement is called
buying on account. The business has a charge account, or open-account credit, with its
suppliers.

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Amounts that a business must pay in the future are known as accounts payable. The
companies or individuals to whom the amounts are owed are called creditors.

ANALYSIS
c. The firm purchased new property (equipment) that cost P155,000.
c. The firm owes P155,000 to Office Plus.
The equation remains in balance.

Office Plus is willing to accept a claim against Wells’ Consulting Services until the bill is
paid. Now there are two different financial interests or claims against the firm’s property—
the creditor’s claim (Accounts Payable) and the owner’s claim (Carolyn Wells, Capital).
Notice that the total property increases to P155,000. Cash is P1,900,000 and equipment
is P255,000. Carolyn Wells, Capital stays the same; but the creditor’s claim increases to
P155,000. After this transaction is recorded, the left side of the equation still equals the
right side.
4. Purchase of supplies through cash payment
Valdez purchased supplies so that Wells’ Consulting Services could start operations. The company
that sold the items requires cash payments from companies that have been in business less than
six months. Wells’ Consulting Services issued a check for P25,000 on September 16, 2021 to
Office Delux, Inc., to purchase office supplies.

ANALYSIS
d. The firm purchased office supplies that cost P25,000.
d. The firm paid P25,000 in cash.
The equation remains in balance. Notice that total property remains the same, even though the
form of the property has changed. Also note that all of the property (left side) equals all of the
financial interests (right side).

5. Paying a creditor
Valdez decided to reduce the firm’s debt to Office Plus by P50,000. Wells’ Consulting Services
issued a check for P50,00 to Office Plus on September 25, 2021.

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ANALYSIS
e. The firm paid P50,000 in cash.
e. The claim of Office Plus against the firm decreased by P50,000.
The equation remains in balance.

6. Renting a facility
At the end of September, Valdez arranged to rent facilities for P18,000 per month, beginning in
December.
The landlord required that rent for the first two months—December and January—be paid in
advance. The firm prepaid (paid in advance) the rent for two months. As a result, the firm obtained
the right to occupy facilities for a two-month period. In accounting, this right is considered a form
of property.
Wells’ Consulting Services issued a check for P36,000 to pay for rent for the months of December
and January.

ANALYSIS
f. The firm prepaid the rent for the next two months in the amount of P36,000.
f. The firm decreased its cash balance by P36,000.
The equation remains in balance.

Notice that when property values and financial interests increase or decrease, the total of the
items on one side of the equation still equals the total on the other side.

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At regular intervals, Wells reviews the status of the firm’s assets, liabilities, and owner’s equity in
a financial statement called a balance sheet.
The balance sheet shows the firm’s financial position on a given date. Figure below shows the
firm’s balance sheet on November 30, the day before the company opened for business.
The assets are listed on the left side of the balance sheet and the liabilities and owner’s equity are
on the right side. This arrangement is similar to the equation property equals financial interest.
Property is shown on the left side of the equation, and financial interest appears on the right side.

The balance sheet in the figure above shows:

■ the amount and types of property the business owns,
■ the amount owed to creditors,
■ the owner’s interest.
This statement gives Carolyn Wells a complete picture of the financial position of her business
on November 30.