Philippine Women’s University

CDCEC-BATAAN

CHAPTER 5 FINANCIAL STATEMENTS

Topic Overview:
1. Elements of financial statements in the balance sheet
2. Elements of financial statements in the income statement
Chapter Objective:
At the end of this chapter, students must be able:
1. Explain the concept of asset, liability and equity
2. Explain the concept of income, expense and drawings
3. Explain the concept of capital expenditure and period expenditure
4. Distinguish drawings and expense and income from capital contributions
5. Analyze business transactions and identify the accounting elements affected.

THE ELEMENTS OF FINANCIAL STATEMENTS

The following are the elements of financial statements:
a. Assets
b. Liabilities
c. Equity
d. Income
e. Expense
These are the building blocks of financial statements hence they are called the elements of
financial statements. The elements are analogous to "words" which makes up a sentence. Your
appreciation and understanding of the elements is a crucial factor in your ability to speak the accounting
language.
Classification of elements
The elements of the financial statements are classified into:
a. Elements of financial position b. Elements of financial performance
a. Assets a. Income
b. Liabilities b. Expense
c. Equity
These are the elements that are presented in the These are the elements that are presented in the
balance sheet or statement of financial position. income statement. These elements are important
These are important in assessing business in assessing profitability.
stability and financial condition.

Financial Position
At regular intervals the business will review the status of the firm's assets, liabilities, and owner's equity
in a formal report called a balance sheet, which is prepared to show the firm's financial position on a
given date.

Asset is a resource controlled by the enterprise as a result of past events and from which future
economic benefits are expected to flow to the enterprise (per IFRS Framework). In simple terms, assets
are valuable resources owned by the entity. Assets include cash, cash equivalents, notes receivable,
accounts receivable, inventories, prepaid expenses, property, plant and equipment, investments,
intangible assets and other assets.

Liability is a present obligation of the enterprise arising from past events, the settlement of which is
expected to result in an outflow from the enterprise of resources embodying economic benefits (per
IFRS Framework). A plain definition would be- liabilities are obligations of the entity to outside parties
who have furnished resources. Liabilities include notes payable, accounts payable, accrued liabilities,
unearned revenues, mortgage payable, bonds payable and other debts of the enterprise.

1
 Philippine Women’s University
CDCEC-BATAAN

Equity is the residual interest in the assets of the enterprise after deducting all its liabilities (per IFRS
Framework). Equity may pertain to any of the following depending on the form of business
organization:

 In a sole proprietorship, there is only one owner's equity account because there is only one
owner.
 In a partnership, an owner's equity account exists for each partner.
 In a corporation, owners' equity, or shareholders' or stockholders equity, consists of share capital
or capital stock, retained earnings and reserves representing appropriations of retained earnings
among others.

Performance
If there is an excess of revenue over expenses, the excess represents a profit. Making a profit is the
reason that people risk their money by investing it in a business. A firm's accounting records show not
only increases and decreases in assets, liabilities, and owner's equity but the detailed results of all
transactions involving revenue and expenses.

Income is increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than those
relating to contributions from equity participants (per IFRS Framework).

The definition of income encompasses both revenue and gains. Revenue arises in the course of the
ordinary activities of an enterprise and is referred to by a variety of different names including sales, fees,
interest, dividends, royalties, and rent.

Gains represent other items that meet the definition of income and may, or may not, arise in the course
of the ordinary activities of an enterprise. Gains represent increases in economic benefits and as such are
no different in nature from revenue. Hence, they are not regarded as constituting a separate element.

Expenses are decreases in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurrences of liabilities that result in decreases in equity, other than those
relating to distributions to equity participants (per IFRS Framework).

The definition of expenses encompasses losses as well as those expenses that arise in the course of the
ordinary activities of the enterprise. There are various classes of expenses but they are generally
classified as cost of services rendered or cost of goods sold, distribution costs or selling expenses,
administrative expenses or other operating expenses.

Losses represent other items that meet the definition of expense and may or may not, arise in the course
of the ordinary activities of an enterprise. Losses represent decreases in economic benefits and as such
are no different in nature from other expenses. Hence, they are not regarded as a separate element.

THE ACCOUNT
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 equity) and in the income statement
(income and expenses). Thus, an account may be defined as a detailed record of the increases, decreases
and balance of each element that appears in an entity's financial statements. The simplest form of the
account is known as the "T" account because of its similarity to the letter "T". The account has three
parts as shown:

2
 Philippine Women’s University
CDCEC-BATAAN

THE ACCOUNTING EQUATION

Financial statements tell us how a business is performing. They are the final products of the accounting
process. But how do we arrive at the items and amounts that make up the financial statements? The most
basic tool of accounting is the accounting equation. This equation presents the resources controlled by
the enterprise, the present obligations of the enterprise and the residual interest in the assets. It states that
assets must always equal liabilities and owner's equity.
The basic accounting model:

Note that the assets are on the left side of the equation opposite the liabilities and owner's equity. This
explains why increases and decreases in assets are recorded in the opposite manner ("mirror image") as
liabilities and owner's equity are recorded. The equation also explains why liabilities and owner's equity
follow the same rules of debit and credit.

The logic of debiting and crediting is related to the accounting equation. Transactions may require
additions to both sides (left and right sides), subtractions from both sides (left and right sides), or an
addition and subtraction on the same side (left or right side), but in all cases the equality must be
maintained as shown below:

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

3
 Philippine Women’s University
CDCEC-BATAAN

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:

Recognition and Derecognition

Recognition is the process of incorporating in the balance sheet or income statement an item that meets
the definition of an element of financial statements. It is also called recording. Derecognition is the
removal of an element in the financial statement when it ceases to be an element.

4
 Philippine Women’s University
CDCEC-BATAAN

The Duality Principle

Remember that when an element is recognized (i.e. recorded), it gives rise to the recognition of another
element. Contemporary accounting makes use of double entry system. Under this system, changes on
two elements are recorded every time a transaction is recorded.
Here is another way of summarizing the rules:

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.
TABLE. NORMAL BALANCE
Increase Recorded by Normal Balance
Account Category Debit Credit Debit Credit
Assets  
Liabilities  
Owner’s Equity
Owner’s Capital  
Withdrawals  
Income  
Expenses  

STATEMENT OF FINANCIAL POSITION BALANCE SHEET

Accountants use special accounting terms when they refer to property and financial Interests. For
example, they refer to property that a business owns as the business's assets and to the debts or
obligations of the business as its liabilities. The owner's financial interest is called owner's equity;
sometimes it is called proprietorship or net worth. Owner's equity is the preferred term and is the term
used throughout this book.
ELEMENTS OF FINANCIAL POSITION
A. ASSET
WHAT IS AN ASSET?
An asset is a resource controlled by the business as a result of past transactions and events and from
which future economic benefits are expected to flow to the business.
Recognition of assets

5
 Philippine Women’s University
CDCEC-BATAAN

An asset is recognized in the balance sheet when it is probable that the future economic benefits will
flow to the business and the asset has a cost or value that can be measured reliably.

ELEMENTS OF AN ASSET:
a. Assets are resources controlled by the enterprise
b. Assets are results of past transactions or events
C. Assets are expected to provide future economic benefits
d. Assets have cost or value that can be measured reliably

An entity shall classify all other assets as non-current. Operating cycle is the time between the
acquisition of materials entering into a process and its realization in cash or an instrument that is readily
convertible to cash.

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. 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. 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 expenses.
Non-Current Assets

Property and Equipment. 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. 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.
TABLE DUALITY EFFECT

6
 Philippine Women’s University
CDCEC-BATAAN

A. An increase in asset of the business may either This is recorded in accounting as

be:
a. An income earned Increase in asset AND increase in income
b. An asset borrowed Increase in asset AND increase in liability
c. Additional investment Increase in asset AND increase in capital
d. An asset received exchange for another asset Increase in asset AND decrease in asset

B. An decrease in asset of the business may either This is recorded in accounting as

be:
a. Payment of expense Decrease in asset AND increase in expense
b. Payment of liability Decrease in asset AND decrease in liability
c. Withdrawal Decrease in asset AND decrease in capital

WHAT IS AN LIABILITY?

Liabilities
An entity shall classify a liability as current when:
a. it expects to settle the liability in its normal operating cycle;
b. it holds the liability primarily for the purpose of trading;
c. the liability is due to be settled within twelve months after the end of the reporting period; or
d. the entity does not have an unconditional right to defer settlement of the liability for at least twelve
months after the end of the reporting period.

An entity shall classify all other liabilities as non-current:

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 other needed assets. They obtain these funds by issuing bonds. The

7
 Philippine Women’s University
CDCEC-BATAAN

bond is a contract between the issuer and the lender specifying the terms of repayment and the interest to
be charged.
TABLE DUALITY EFFECT
A. An increase in liability of the business may This is recorded in accounting as
either be:
a. An asset which is borrowed Increase in liability AND increase in asset
b. An expense which accrued Increase in liability AND increase in expense
c. A replacement to another liability Increase in liability AND decrease in liability
B. A decrease in liability of the business occurs Decrease in liability AND decrease in asset
when it is paid

WHAT IS AN OWNER’S EQUITY?

Owner's Equity
Capital. 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 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 to the capital account.
TABLE DUALITY EFFECT
A. An increase in equity of the business may either This is recorded in accounting as
be:
a. An asset contributed the owners Increase in equity AND increase in asset
b. A liability converted to equity Increase in equity AND decrease in liability
B. A decrease in equity of the business it return of Decrease in equity AND decrease in asset
capital to the owners