Lesson 1 The Accounting Equation and The Double-Entry System

The Accounting
Equation and the

Double-Entry System
10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

Lesson #1
Learning Objectives
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 simple T-account and its uses.
Understand what is meant by the accounting equation and prove the validity of the “mirror
image” concept

Lesson #1
Learning Objectives
Understand what is meant by the double-entry system.
Explain how the double-entry system follows the rules of the accounting equation.
Define debits and credits.
Summarize the rules of debit and credit as applied to balance sheet and income statement
accounts.
Describe the nature of the typical account titles used in recording transactions.

Lesson #1
Learning Objectives
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.
Distinguish between receipts and revenue.

Lesson #1
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.
 People are competent end users working to increase their productivity.

End users use hardware and software to solve information-related or
People decision-making problems.
 Procedures are manuals and guidelines that instruct end users on how to
Procedures use the software and hardware.
 Software is another name for programs—instructions that tell the

Software computer how to process data.

Lesson #1
 System software is a background software that helps a computer manage
its internal resources. An example if the operating system. Windows and
System Software Linux are popular operating systems.
 Application Software performs useful work on general-purpose problems.

Application Software The two types of applications software are basic applications and
advanced applications.
 Basic applications include: browsers, word processors, spreadsheet,
presentation graphics, and database management system.
 There also advanced applications which include: multimedia, web
publishers, graphics programs, virtual reality artificial intelligence, and
project managers.

Lesson #1
 Hardware consists of input devices, the system unit, secondary storage,
output devices, and communication devices.
Hardware
 Input devices translate data and programs that humans can understand
Input devices into a form the computer can process. The more common are the
keyboard, mouse, scanner, digital camera, and microphone.
 The system unit consists of electronic circuitry with two parts:

System unit  Central processing unit (CPU)
 Memory (primary storage)

Lesson #1
 It stores data and programs. The three most common storage media are
Secondary flash drive, hard disk, and optical disk.
Storage
 Output devices output processed information from the CPU. The two
Output devices important output devices are the monitor and printer.
 These send and receive data and programs from one computer to
Communication another. A device that connects a microcomputer to a telephone is a
Devices modern one.

Lesson #1
 Data is the raw material for data processing.
 It consists of numbers, letters, and symbols and relates to the facts,
Data events, and even 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
 Database.

Lesson #1
Accounting Information System
Every business organization must have an accounting information system which will
generate reliable financial information needed by the decision-makers.
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 firm’s size, nature of operations, volume of transaction data, organizational structure,
form of business, and extent of government regulation all influence the way in which
information is accumulated and reported in the financial statements.

Lesson #1
An accounting information system is the combination of personnel, records, and procedures
that a business uses to meet its need for financial information.
Most companies have an accounting manual that specifies the policies and procedures to be
followed in accumulating information within the accounting information system.
This manual details the events that are to be recorded in the accounts, when, and how the
information is to be classified and accumulated,

Lesson #1
This diagram illustrates how economic activities flow into the accounting process, which
produces accounting information.
This information is used by decision makers in making economic decisions and in taking
specific actions.

Lesson #1
Accounting Information System:
Types Generally, companies use three types of accounting information systems to record the
results of transactions: manual systems, computer-based transaction systems, and database
systems.
 They utilize paper-based journals(both general and special) and ledgers

(general and subsidiary).
Manual Systems
 They rely on human processing.
 They may be prone to error.

Lesson #1
Types
Computer-based  Manual systems rely on human processing which means that they are
labor intensive and may be insufficient in today’s complex business
Transaction Systems environment.
 Due to this, they may be prone to error.
 To overcome this, companies have computerized their accounting

processes.
 A computer-based transaction system maintains accounting data

separately from other operating data.
 Accounting records are kept separately from the records required for the
expenditure, revenue, and conversion processes.

Lesson #1
Types
Computer-based  This system treats information in the same manner as manual system.
Transaction Systems  The user is simply filling in a computer screen that looks and oftentimes
acts like a source document.
 Some of the advantages of this system are:

 Quickly posting of transactions to appropriate accounts.
 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.
 A wide variety of reports can be prepared.
 Accounting packages also consist of modules.

 These are programs which deal with one particular part of a business
accounting system.

Lesson #1
Types  Relational database systems such as enterprise resource planning (ERP)
Database Systems depart from the “accounting equation: method of organizing data.
 Database systems reduce inefficiencies and redundancies that often exist

in transaction-based systems.
 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.

Lesson #1
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 must be supported by source
documents such as customer invoices, vendor invoices, deposit slips, checks, etc.
These documents serve as evidence that a particular transaction has occurred.
The computer, with the use of the accounting software, then processes the inputs.
If required, the financial statements and other accounting reports can be viewed on the
screen or be printed as output documents.

Lesson #1
Elements of Financial Statements
In summary, here are the elements of financial statements.

Lesson #1
Elements of Financial Statements: Asset
 An asset is a present economic resource controlled by the entity as a
result of past events.
Assets
 An economic resource is a right that has the potential to produce
economic benefits.
 There are three aspects to these definitions: “right”; “potential to produce

economic benefits”; and “control”.
 The rights that have the potential to produce economic benefits take
many forms including:
 Rights that correspond to an obligation of another party
 Ex. rights to receive cash/goods/services
 Rights that do not correspond to an obligation of another party
 Ex. rights to use intellectual property

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 An economic resource could produce economic benefits for an entity,
for example:
Assets  Receive contractual cash flows or another economic resource.
 Exchange economic resources with another party on favorable
terms.
 Produce cash inflows or avoid cash outflows by:
 Using economic resource individually or in combination with
others to produce goods and provide services
 Using economic resource to enhance the value of other
economic resources
 Leasing the economic resource to another party
 An entity also controls an economic resource i

Lesson #1
 An entity also controls an economic resource if it has the present
ability to direct the use of the economic resource and obtain the
Assets economic benefits that may flow from it.
 “Control” may include 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.
 If one party controls an economic resource, no other party
controls that resource.

Lesson #1
Elements of Financial Statements:
Liability
Liability
 A liability is a present obligation of the entity to transfer an economic
resource as a result of past events.
 For a liability to exist, three criteria must all be satisfied:

 The entity has an obligation
 The obligation is to transfer an economic resource
 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.
 It is always owed to another party/parties.
 If one party has an obligation to transfer an economic resource, it follows

that another party has a right to receive that economic resource.

Lesson #1
Liability
Liability
 Some examples of obligations to transfer an economic resource include:
 Obligations to pay cash
 Obligations to deliver goods and provide services
 Obligations to transfer an economic resource if a specified future
event occurs
 A present obligation exists as a result of past events if and only if:

 The entity has already obtained economic benefits or taken an action
 And as a consequence, the entity will or may have to transfer an
economic resource that it would not otherwise have had to transfer.

Lesson #1
Equity
Equity
 Equity is the residual interest in the assets of the enterprise after
deducting all its liabilities.
 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:
 In a sole proprietorship, there is only one owner’s equity account
since there is only one power
 In a partnership, an owner’s equity account exists for each partner
 In a corporation, owner’s equity or stockholder’s equity consists of
share capital, retained earnings and reserves representing
appropriations of retained earnings among others.

Lesson #1
Financial Performance
 Income increases in assets, or decreases in liabilities, that result in
Financial increases in equity, other than those relating to contributions from holders
Performance 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.
 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.

Lesson #1
The Account
The account is the basic summary device of accounting.
A separate account is maintained for each element that appears in the balance sheet 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 with
the letter “T”.

Lesson #1
The Account: T-Account

Lesson #1
The Accounting Equation
The most basic tool of accounting is the accounting equation.
Basically, 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 is: Assets = Liabilities + Owner’s Equity
The logic of debiting and crediting is also related to this equation.

Lesson #1
The Accounting Equation
Transactions may require additions/subtractions/both to both sides of equation, but in all
cases the equality must be maintained as shown below:

Lesson #1
Debit and Credit – 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.
Most importantly, the total debits for a transaction must always equal the total credits.

Lesson #1
System 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.
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 of the account).
Conversely, increases in liabilities and owner’s equity are recorded by credits and decreases
are entered as debits.

Lesson #1
System Here are the rules of Debit and Credit:

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Lesson #1
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.

Lesson #1
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.
Ex. Acquiring assets from owner/s, borrowing funds from creditors, purchasing or selling
goods and services.

Lesson #1
Types and Effects of Transactions
1. Source of Assets (SA) – An asset account increases and a corresponding claims (liabilities or owner’s
equity) account increases. Ex. Purchase of supplies on account.
2. Exchange of Assets (EA) – One asset account increases and another asset account decreases. Ex.
acquired equipment of cash
3. Use of Assets (UA) – An asset account decreases and a corresponding claims (liabilities or equity)
account decreases. Ex. settled accounts payable
4. Exchange of Claims (EC) – One claims (liabilities or owner’s equity) account increases and another
claims (liabilities or owner’s equity) account decreases. Ex. Received
utilities bill but did not pay.

Lesson #1
Types and Effects of Transactions
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 mentioned in the previous slide may be further
expanded into nine types of effects as follows:

Lesson #1
Typical Account Titles Used: Assets
Assets should be classified only into two: current assets and non-current assets.
An asset is current when:

a. 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 unless the asset is restricted from being
exchanged or used to settle a liability for at least twelve months after the reporting
period.
Operating cycle is the time between the acquisition of assets for processing and their
realization in cash or cash equivalents.
All other assets not stated should be classified as non-current assets.

Lesson #1
Typical Account Titles Used: Assets
 Current Assets include:
 Cash
Current Assets  Cash equivalents
 Notes Receivable
 Accounts receivable
 Inventories
 Prepaid Expenses
 Non-current Assets include:

Non-current Assets  Property, Plant, and Equipment
 Accumulated Depreciation
 Intangible Assets

Lesson #1
Typical Account Titles Used: Liabilities
An entity should 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 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 reporting period.
All other liabilities not stated should be classified as non-current liabilities.

Lesson #1
Typical Account Titles Used: Liabilities
 Current Liabilities include:
 Accounts payable
Current Liabilities  Notes payable
 Accrued Liabilities
 Unearned revenues
 Current Portion of Long-Term Debt
Non-current  Non-current Liabilities include:

 Mortgage payable
Liabilities  Bonds payable

Lesson #1
Typical Account Titles Used: Owner’s
Equity  Owner’s Equity include:
Owner’s Equity
 Capital
 Withdrawals
 Income Summary

Lesson #1
Typical Account Titles Used: Income
Statement
Income
 Income includes:
 Service income
 Sales
 Expenses include:
 Cost of sales
Expenses  Salaries or Wages Expense
 Telecommunications, Electricity, Fuel, and Water Expenses
 Rent Expense
 Supplies Expense
 Insurance Expense
 Depreciation Expense
 Uncollectible Accounts Expense
 Interest Expense

Lesson #1
Accounting for Business Transactions
Accountants observe many events that they identify and measure in financial terms.
A business transaction is the occurrence of an event or a condition that affects the

financial position and can be reliably recorded.
Every financial transaction can be analyzed or expressed in terms of its effects on the
accounting equation. The 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.
See the following slides for an example problem.

Lesson #1
Accounting for Business Transactions:
Example Problem

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Example Problem

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Example Problem

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Example Problem

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Example Problem

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Example Problem

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Example Problem

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Example Problem

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Example Problem

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Example Problem

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Example Problem

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Example Problem

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Example Problem
If the number of accounts involved increases, this method is not an efficient approach.
Once it happens, double-entry system or the T-Account may be used.

Lesson #1
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”.

Lesson #1
END OF LESSON NO. 1
Any Questions?

Lesson #1

Lesson 1 The Accounting Equation and The Double-Entry System

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The Accounting

Equation and the

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

Explain how an accounting information system helps the decision makers.

Define the elements of financial statements.

Describe the simple T-account and its uses.

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

Define debits and credits.

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

Distinguish between receipts and revenue.

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

 People are competent end users working to increase their productivity.

 Software is another name for programs—instructions that tell the

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

 Application Software performs useful work on general-purpose problems.

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

 The system unit consists of electronic circuitry with two parts:

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

 They utilize paper-based journals(both general and special) and ledgers

 They may be prone to error.

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

 Due to this, they may be prone to error.

 To overcome this, companies have computerized their accounting

 A computer-based transaction system maintains accounting data

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

 Some of the advantages of this system are:

 Accounting packages also consist of modules.

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

 Database systems reduce inefficiencies and redundancies that often exist

 Advantages of database systems include:

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

These documents serve as evidence that a particular transaction has occurred.

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

 There are three aspects to these definitions: “right”; “potential to produce

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

 An entity also controls an economic resource i

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

 “Control” may include the present ability to prevent other parties

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

 For a liability to exist, three criteria must all be satisfied:

 An obligation is a duty or responsibility that an entity has no practical

 It is always owed to another party/parties.

 If one party has an obligation to transfer an economic resource, it follows

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

 A present obligation exists as a result of past events if and only if:

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

 Equity may pertain to any of the following depending on the form of

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

 Expenses are decreases in assets, or increases in liabilities, that result in

 Contributions from holders of equity claims are not income, and

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING

The basic accounting model is: Assets = Liabilities + Owner’s Equity

The logic of debiting and crediting is also related to this equation.

10/28/22 BASIC FINANCIAL ACCOUNTING & REPORTING