LESSON NUMBER 2

LESSON TITLE: ANALYZING TRANSACTIONS IN STARTING A BUSINESS

Lesson Objectives: At the end of the lesson, students are expected to:

1. Define the basic elements of accounting.

2. Use the accounting equation to analyze business transactions in starting a business.

FINANCIAL STRUCTURE OF A BUSINESS ORGANIZATION

BUSINESS
ENTITY
ASSETS Liabilities P500,000
=
P2,500,000 Owner’s Equity P2,000,000

The figure above shows how accounting views the financial structure of a business entity. The structure
should contain three values or basic elements called assets, liabilities, and owner’s equity. The structure shows the
assets on one side (left) and the liabilities and owner’s equity on the other side (right). The financial structure also
shows the relationship among these three accounting values – that the assets are claimable by the creditors
(represented by liabilities) and investors (represented by owner’s equity) and therefore should always be equal.

ELEMENTS OF STATEMENT OF FINANCIAL POSITION

Real Accounts are also called Balance Sheet Accounts or Permanent Accounts since they carry on to the next
accounting Period. These accounts show the financial position of the business which includes the Assets, Liabilities,
and Owner’s Equity or Capital.
Nominal Accounts, on the other hand, are also called Income Statement Accounts or Temporary accounts since
they are only applicable in their accounting period. These accounts show the financial performance of the business in
the accounting year and include income, expenses, and withdrawals of the business.

1. Assets refer to things of value owned by the business. They benefit the business, are being used in operating
the business, and are expected to have a long life. Initially, assets or business resources will come from
investors (sole proprietor, partner, or shareholder) and secondarily from creditors (from a bank for money
and from suppliers for goods and supplies bought and services received). Therefore, assets are claimable by
two parties – creditors and investors. When the entity’s normal operating cycle is not clearly identifiable, it
is assumed to be twelve months.

For example, an asset may be:

 Used singly or in combination with other assets in the production of goods or services to be sold by the
enterprise;
 Exchanged for other Assets;
 Used to settle a liability; or
 Distributed to the Owners of the enterprise.

Classification of Assets

Current assets are assets that can be converted into cash within one fiscal year or one operating cycle.
Current assets are used to facilitate day-to-day operational expenses and investments. Examples of current assets:
are cash, accounts receivable, inventory, Prepaid Expenses, and Other Current Assets (Supplies).
 Non-Current Assets- these are sometimes called long-term assets since they would not be completely
consumed in the current operation cycle. Examples of non-current assets: Property, Plant, and Equipment,
Accumulated Depreciation, Investment Properties, Investments, Intangible Assets, and Other Non-Current Assets.

2. Liabilities refer to amounts owed to lenders and suppliers. Liabilities often have the word "payable" in the
account title. Liabilities also include amounts received in advance for a future sale or for future service to
be performed.
An entity shall classify a liability as Current when:

 It expects to settle the liability in its normal operating cycle;

 It holds 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
months after the reporting period.
All other liabilities should be classified as non-current liabilities.

Examples of Current Liabilities: Accounts Payable, Notes Payable, Accrued Liabilities, Unearned Revenues,
Income Tax Payable, and the Current portion of long-term debt.

Examples of Non-Current Liabilities: Loans Payable, Mortgage Payable, Long Term Notes Payable, Bonds
Payable, and Other Noncurrent Liabilities.

3. Owner’s Equity or Net Worth represents the residual interest of the owner in the entity’s assets. In a
partnership since there are more owners, the appropriate title is the partner’s equity. In a corporation since
there are many investors, it is called shareholder’s equity.

 Capital- (from the Latin word capitalis, meaning “property”). This 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.
 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 is a 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 the capital
account.

4. Income- is the net increase in assets in a given accounting period. It may be due to increases in assets or
decreases in liabilities. This is result in an increase in equity except those related to contributions by investors.
It is usually the result of providing goods and services or from investment income.

5. Expenses- on the other hand, are the costs of businesses during their operations. These are decreases in assets
or increases in liabilities. This results in a decrease in equity except for those related to distributions to holders
of equity claims.

THE ACCOUNTING EQUATION

An accounting equation would always have an equal left side and right side. There are no transactions where
the left side is higher than the right side and vice versa. Always keep in mind to preserve the balance on both sides in
order not to make any errors in accounting and recording transactions. Say all assets are invested solely by the owner,
the accounting equation is simply:

Assets = Owner’s Equity

If the assets came from a mixture of investors and creditors, the equation will look like this:
Assets = Liabilities + Owner’s Equity
ILLUSTRATIVE PROBLEM:

The following transactions pertaining to the travel business owned by Mr. N show how the transactions in
the formation of his business can affect the accounting equation:

Jan 1, 2020 Mr. N opened a tour and travel agency by investing cash P50,000. He has three cars worth
P1,000,000 but decided to invest only two of these cars worth P750,000.

Analysis: The assets of the business will increase in the form of cash P50,000 and cars P750,000
with a corresponding increase in owner’s equity.

Increase in ASSETS = LIABILITIES + Increase in Owner’s Equity

Cash P50,000 Mr. N, capital P800,000
Cars 750,000

Jan 3, 3030 Mr. N borrowed P100,000 cash from a bank for use in his business.

Analysis: The assets of the business will increase again in cash by P100,000 with a corresponding
increase in liability.

Increase in ASSETS = Increase in LIABILITIES + Owner’s Equity

Cash P100,000 *Loans Payable P100,000

*Loans Payable is an account used for borrowings made in a bank. Other accounts in the liabilities section
include Accounts Payable, Note Payable, and Income Tax Payable, among others.

Jan 7, 2020 Mr. N bought tables and chairs from a local supplier and paid cash of P45,000.

Analysis: The assets of the business will increase in the form of furniture and decrease in the form
of cash. Total assets will remain unchanged since both accounts in part of the assets. Note that even
if there is no change in the right side of the equation (liabilities and owner’s equity), the accounting
equation will remain its balance since the transaction involves increasing and decreasing the asset
by the same amount.

Increase and Decrease in ASSETS = Liabilities + Owner’s Equity

Cash (-) P45,000
Furniture (+) 45,000

Jan 15, 2020 Various equipment was purchased on account from National Winners for P55,000.

Analysis: The assets of the business will increase in the form of equipment with a corresponding
increase in liabilities.

Increase in ASSETS = Increase in LIABILITIES + Owner’s Equity

Equipment P55,000 *Accounts Payable P55,000

*The account “Accounts Payable” is used for short-term borrowings not evidenced by a promissory note
usually from a known supplier. The account ‘Notes Payable” is the one used for borrowings where a
promissory note is given by the borrower.

Jan 18, 2020 Mr. N made a cash withdrawal of P5,000 for personal use
 Analysis: The assets of the business will decrease in the form of cash P5,000 with a corresponding
decrease in the owner’s equity since the owner recovered his investment by withdrawing cash.

Decrease in ASSETS = LIABILITIES + Decrease in Owner’s Equity

Cash P5,000 *Mr. N, Drawing P5,000

*The “Mr. N, Drawing” account is considered as a deduction to the total owner’s equity section. This account
is the opposite of the capital account which we recorded as “Mr. N, capital” which represents the total
investments made by the owner whereas the drawing account represents the total deductions to the
investments made by the owner.

Jan 20, 2020 The account due to National Winners was paid in cash.

Analysis: Assets of the business will decrease in the form of cash with a corresponding decrease in
liabilities.

Decrease in ASSETS = Decrease in LIABILITIES + Owner’s Equity

Cash P55,000 Accounts Payable P55,000
The following table summarizes the effect of these transactions on the accounting equation with balances given after
each transaction to prove the accounting equation:

Date ASSETS LIABILITIES OWNER'S EQUITY

January Cash Cars Equipment Furniture Loans Payable Accounts Payable Mr. N, capital Mr. N, drawings
1 50,000 750,000 800,000
3 100,000 100,000
Bal. 150,000 750,000 - - 100,000 - 800,000 -
7 - 45,000 45,000
Bal. 105,000 750,000 - 45,000 100,000 - 800,000 -
15 55,000 55,000
Bal. 105,000 750,000 55,000 45,000 100,000 55,000 800,000 -
18 - 5,000 - 5,000
Bal. 100,000 750,000 55,000 45,000 100,000 55,000 800,000 - 5,000
20 - 55,000 - 55,000

Balances 45,000 750,000 55,000 45,000 100,000 - 800,000 - 5,000

*Getting the totals, the total assets will be P895,000, total liabilities at P100,000, and total owner’s equity at P795,000.
The total of the right side of the equation (Assets) will be P895,000 and the left side (Liabilities & Owner’s equity)
will have the same total. The accounting equation retained its balance after accounting for several accounting
transactions.

PRESENTATION OF STATEMENT OF FINANCIAL POSITION

The first three basic elements: assets, liabilities, and owner’s equity are presented in a report called the
Statement of Financial Position where a user will be able to determine the following information:
1. Wealth accumulated by the business,
2. Its net worth
3. Its liquidity and solvency

It was previously called Balance Sheet before PAS 1 was revised in 2007 because it shows the balances of
each account and the grand total shows a balance between the assets (business resources) on one hand and the liabilities
and owner’s equity (claim over the assets) on the other.
 The Statement of Financial Position often called the Balance Sheet, is a financial statement that reports
the assets, liabilities, and equity of a company on a given date. In other words, it lists the resources, obligations, and
ownership details of a company on a specific day. You can think of this as a snapshot of what the company looked
like at a certain time in history.

Presented below is the interim statement showing the financial position of the previous illustration for Mr.
N’s Travel and Tours business. Note that this statement is not prepared every time there is a transaction or a change
in the accounting equation. This statement is usually prepared every accounting year-end and interim statements are
prepared as needed by the statement users.

Mr. N Travel and Tours

Statement of Financial Position
January 20, 2020
ASSETS LIABILITIES AND OWNER'S EQUITY
Cash 45,000 Loans Payable 100,000
Cars 750,000 Mr. N, Capital 795,000
Equipment 55,000
Furnitures & Fixtures 45,000
Total 895,000 Total 895,000

*The capital account is already presented net of drawings (P800,000 – P5,000), P795,000.

SUMMARY OF THE LESSON

 The three basic accounting elements are assets, liabilities, and owner’s equity.
 In a business transaction, there must be an: a. EXCHANGE OF VALUES; b. between TWO PARTIES; c. in
terms of MONEY.
 An account is a brief description of items representing each of the accounting elements.
 The accounting equation is Assets = Owner’s Equity OR Assets = Liabilities + Owner’s Equity.
 The Statement of Financial Position contains the assets accumulated by the business, liabilities it owed,
and its net worth. From this information, you will be able to determine if the business is liquid or solvent.

REFERENCES

1. Vera Cruz-Manuel. Simplified Accounting for Business: Basic Concepts and Procedures. 2016.
2. Wilma C. Miranda. Fundamentals of Accounting, Business and Management
3. https://www.accountingcoach.com/terms/L/liabilities
4. https://www.myaccountingcourse.com/financial-statements/statement-of-
financialposition#:~:text=What%20is%20the%20Statement%20of%20Financial%20Position%3
F%20The,details%20of%20a%20company%20on%20a%20specific%20day.
5. Warren, Reeve, Duchac. Accounting 2E (2nd Edition)
6. Ballada, Win. Basic Accounting Made Easy (18th Edition)