Topic 4 The Accounting Equation and the Double-Entry System Part 1

 The starting point in the accounting process is an  To protect entity's assets, to ensure that data are
analysis of the transactions of a business. reliable, and to minimize wastes and the
possibility of theft or fraud (control principle).
Business transaction- any financial event that changes the  To be in harmony with the entity's organizational
resources of a firm. and human factors (compatibility principle).
 To be able to accommodate growth in the volume
EXAMPLE:
of transactions and for organizational changes
Purchases, sales, payments and receipt of cash are all (flexibility principle).
business transactions. The accountant must look at the
effects of each business transaction to decide what
information to record and where to record it. Thus, the
study of accounting begins with an investigation into CONOMIC ACTIVITIES THE ACCOUNTING PROCESS
how the accountant analyzes business transactions. `

Learning Objective: Distinguish between accounting event DECISION MAKERS ACCOUNTING INFORMATION
and transaction.
The above diagram illustrates how economic activities
ACCOUNTING EVENTS AND TRANSACTIONS flow into the accounting process, which produces
accounting information.
Accounting Events- is an economic occurrence that causes
changes in an enterprise's assets, liabilities, and/or equity
TYPES OF ACCOUNTING INFORMATION SYSTEMS
Events may be internal actions, such as the use of
equipment for the production of goods or services. Three types of accounting information systems to record
It can also be an external event, such as the the results of transactions:
purchase of raw materials from a supplier.
1. Manual systems-utilize paper-based journals
Transaction- particular kind of event that involves the (general and special) and ledgers (general and
transfer of something of value between two entities. subsidiary).
2. Computer-based transaction systems
EXAMPLE: include acquiring assets from owner(s),
3. Database systems-embed accounting data within
borrowing funds from creditors, and purchasing or selling
the business event data on which they are based.
goods and services.
All of these systems are designed to capture
ACCOUNTING INFORMATION SYSTEM information regarding accounting events to
prepare financial statements.
Every business organization must have an
accounting information system which will Discussion Question: Enumerate the elements of
generate reliable financial information needed by financial statements. Define each briefly.
the decision-makers in a timely manner.
ELEMENTS OF FINANCIAL SYSTEM
The design of the system to meet the entity's
information requirement depends on the firm's Financial Position
size, nature of operations, volume of transaction
data, organizational structure, form of business -At regular intervals the business will review the status of
and extent of government regulation. These will the firm's assets, liabilities, and owner's equity in a formal
influence the way information is accumulated and report called a balance sheet, which is prepared to show
reported in the financial statements. the firm's financial position on a given date.
Generate reliable financial information needed
by the decision-makers in a timely manner. ASSET- is a resource controlled by the enterprise

(What must be considered before its setup?) - valuable resources owned by the entity

-An accounting information system is the combination of - include cash, cash equivalents, notes receivable,
personnel, records and procedures that a business uses to accounts receivable, inventories, prepaid expenses,
meet its need for financial information property, plant and equipment, investments, intangible
assets and other assets.
 Most firms have an accounting manual
-This manual details what events are to be LIABILITY- is a present obligation of the enterprise arising
recorded in the accounts, and when and how the from past events
information is to be classified and accumulated.
-expected to result in an outflow from the
Learning Objective: Explain how an accounting enterprise of resources embodying economic
information system helps the decision makers. benefits (per IFRS Framework).
-obligations of the entity to outside parties who
An effective accounting information system should achieve have furnished resources.
the following objectives: - include notes payable, accounts payable, accrued
liabilities, unearned revenues, mortgage payable,
 To process the information efficiently at the least bonds payable and other debts of the enterprise.
cost (cost-benefit principle).
Discussion Question: How do sole proprietorships,
partnerships and corporations differ with regard to equity.
Topic 4 The Accounting Equation and the Double-Entry System Part 1
EQUITY- Residual interest in the assets of the enterprise THE ACCOUNTING EQUATION
after deducting all its liabilities (per IFRS Framework).
Financial statements tell us how a business is
-Equity may pertain: performing.

 In a sole proprietorship, there is only one owner's -They are the final products of the accounting process.
equity account because there is only one owner.
 In a partnership, an owner's equity account exists The most basic tool of accounting is the
for each partner. accounting equation.
 In a corporation, owners' equity, or shareholders' -This equation presents the resources controlled by the
or stockholders' equity, consists of share capital or enterprise, the present obligations of the enterprise and
capital stock, retained earnings and reserves the residual interest in the assets
representing appropriations of retained earnings
among others. It states that assets must always equal liabilities
and owner's equity.
PERFORMANCE
ASSETS=LIABILITIES+OWNER’S EQUITY
-If there is an excess of revenue over expenses, the excess
represents a profit. o This explains why increases and decreases in
assets are recorded in the opposite manner
INCOME
("mirror image") as liabilities and owner's equity
- Increases in economic benefits during the accounting are recorded.
period in the form of inflows or enhancements of assets or o The equation also explains why liabilities and
decreases of liabilities that result in increases in equity owner's equity follow the same rules of debit and
credit.
The definition of income encompasses both The logic of debiting and crediting is related to the
revenue and gains. accounting equation

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

-They are not regarded as constituting a separate element.

DEBITS AND CREDITS—THE DOUBLE-ENTRY SYSTEM

Expenses are decreases in economic benefits during the
accounting period in the form of outflows or depletions of Accounting is based on a double-entry system
assets or incurrence’s of liabilities that result in decreases which means that the dual effects of a business
in equity transaction is recorded.

Losses represent other items that meet the definition of -A debit side entry must have a corresponding credit side
expense and may or may not, arise in the course of the entry.
ordinary activities of an enterprise.
Each transaction affects at least two accounts. The
-represent decreases in economic benefits and as such are total debits for a transaction must always equal
no different in nature from other expenses. Hence, they are the total credits.
not regarded as a separate element.
-An account is debited when an amount is entered on the
Discussion Question: What is the basic summary device of left side of the account
accounting? What does it contain?
-credited when an amount is entered on the right side.
Learning Objective: Describe the account (the simple T-
account and its uses) The abbreviations for debit and credit are Dr. (from the
Latin debere) and Cr. (from the Latin credere),
THE ACCOUNT respectively.

The basic summary device of accounting is the Discussion Question: State the rules of debit and credit.
account.
The account type determines how increases or
Separate account- is maintained for each element that decreases in it are recorded.
appears in the balance sheet (assets, liabilities and equity)
and in the income statement (income and expenses). -Increases in assets are recorded as debits (on the left
side of the account)
The simplest form of the account is known as the "T"
account because of its similarity to the letter "T" - Decreases in assets are recorded as credits (on the right
side) conversely
Topic 4 The Accounting Equation and the Double-Entry System Part 1
Increases in liabilities and owner's equity are An entity shall classify an asset as current when:
recorded by credits and decreases are entered as
debits. a) it expects to realize the asset, or intends to sell or
The rules of debit and credit for income and consume it, in its normal operating cycle;
expense accounts are based on the relationship of b) it holds the asset primarily for the purpose of
these accounts to owner's equity. Income trading;
increases owner's equity and expense decreases c) it expects to realize the asset within twelve
owner's equity. Hence, increases in income are months after the end of the reporting period;
recorded as credits and decreases as debits. d) the asset is cash or a cash equivalent unless it is
Increases in expenses are recorded as debits and restricted from being exchanged or used to settle
decreases as credits. These are the rules of debit a liability for at least twelve months after the end
and credit. of the reporting period.
An entity shall classify all other assets as non-
current.

Current Assets

Cash-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

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;
c) In the form of materials or supplies to be
NORMAL BALANCE OF AN ACCOUNT
consumed in the production process or in the
Increases NORMAL rendering of services.
Recorded By BALANCE
Discussion Question: Explain the concept of prepaid
expenses.
Acc. Categ. Debit Credit Debit Credit
Assets ✔ ✔ Prepaid Expenses- These are expenses paid for by the
Liabilities ✔ ✔ business in advance.
Owner’s
Equity: -It is an asset because the business avoids having to pay
Owner’s ✔ ✔ cash in the future for, a specific expense.
capital
Withdrawal ✔ ✔ Non-Current Assets
Income ✔ ✔
Expenses ✔ ✔ Property and Equipment- These are tangible assets that
TYPICAL ACCOUNT TITLES USED are held by an enterprise for use in the production or
supply of goods or services, or for rental to others, or for
BALANCE SHEET administrative purposes and which are expected to be
used during more than one period.
-Accountants use special accounting terms when they refer
to property and financial interests. -Included are such items as land, building, machinery and
equipment, furniture and fixtures, motor vehicles and
EXAMPLE: they refer to property that a business owns as equipment.
the business's assets and to the debts or obligations of the
business as its liabilities. The owner's financial interest is Accumulated Depreciation- It is a contra account that
called owner's equity; sometimes it is called proprietorship contains the sum of the periodic depreciation charges.
or net worth. Owner's equity is the preferred term and is
the term used throughout this book. The balance in this account is deducted from the
cost of the related asset—equipment or buildings
ASSETS —to obtain book value.

CLASSIFIED INTO 2: current assets and non-current assets.

Topic 4 The Accounting Equation and the Double-Entry System Part 1
Intangible Assets- These are identifiable, nonmonetary Owner's Equity
assets without physical substance held for use in the
Capital- This account is used to record the original and
production or supply of goods or services, for rental to
others, or for administrative purposes. additional investments of the owner of the' business
entity.
-These include goodwill, patents, copyrights, licenses,
franchises, trademarks, brand names, secret processes, -This account title bears the name of the owner.
subscription lists and non-competition agreements. Withdrawals- When the owner of a business entity
Liabilities withdraws cash or other assets, such are recorded in
the drawing or withdrawal account rather than directly
An entity shall classify a liability as current when: reducing the owner's equity account.
a) it expects to settle the liability in its normal Income Summary- It is a temporary account used at the
operating cycle
end of the accounting period to close income and
b) it holds the liability primarily for the purpose of
trading; expenses.
c) the liability is due to be settled within twelve
-This account shows the profit or loss for the period
months after the end of the reporting period; or
d) The entity does not have an unconditional right to before closing to the capital account.
defer settlement of the liability for at least twelve
INCOME STATEMENT
months after the end of the reporting period.
An entity shall classify all other liabilities as non- Income- Revenue, or income, is the inflow of money or
current. other assets (including claims to money, such as sale
Current Liabilities made on credit) that results from sales of goods or
services or from the use of money or property. The
Accounts Payable- This account represents the reverse result of revenue is an increase in assets.
relationship of the accounts receivable. By accepting
the goods or services, the buyer agrees to pay for them Service Income- Revenues earned by performing
in the near future. services for a customer or client; for example,
accounting services by a CPA firm, laundry services by a
Notes Payable- A note payable is like a note receivable laundry shop.
but in a reverse sense. In the case of a note payable, the
business entity is the maker of the note; Sales- Revenues earned as a result of sale of
merchandise; for example, sale of building materials by
Accrued Liabilities- Amounts owed to others for unpaid a construction supplies firm.
expenses. This account includes salaries payable,
Expenses- involves the outflow of money, the use of other
utilities payable, interest payable and taxes payable.
assets, or the incurring of a liability
Unearned Revenues- When the business entity receives - include the costs of any materials, labor, supplies, and
payment before providing its customers with goods or services used in an effort to produce revenue.
services, the amounts received are recorded in the
unearned revenue account (liability method). When the Cost of Sales- The cost incurred to purchase or to produce
the products sold to customers during the period; also
goods or services are provided to the customer, the
called cost of goods sold.
unearned revenue is reduced and income is recognized.
Salaries or Wages Expense - Includes all payments as a
Current Portion of Long-Term Debt- These are portions result of an employer-employee relationship such as
of mortgage notes, bonds and other long-term salaries or wages, 13th month pay, cost of living
indebtedness which are to be paid within one year from allowances and other related benefits
the balance sheet date.
Telecommunications, Electricity, Fuel and Water Expenses
Non-Current Liabilities
- Expenses related to use of telecommunications facilities,
consumption of electricity, fuel and water.
Mortgage Payable- This account records long-term debt
of the business entity for which the business entity has Supplies Expense-Expense of using supplies (e.g. office
pledged certain assets as security to the creditor. supplies) in the conduct of daily business.

Bonds Payable- Business organizations often obtain Rent Expense Expense for space, equipment or other asset
substantial sums of money from lenders to finance the rentals.
acquisition of equipment and other needed assets. Insurance Expense. Portion of premiums paid on insurance
coverage (e.g. on motor vehicle, health, life, fire, typhoon or
-The bond is a contract between the issuer and the
flood) which has expired.
lender specifying the terms of repayment and the
interest to be charged.
Topic 4 The Accounting Equation and the Double-Entry System Part 1
Depreciation Expense. The portion of the cost of a tangible
asset (e.g. buildings and equipment) allocated or charged
as expense during an accounting period.

Uncollectible Accounts Expense. The amount of receivables

estimated to be doubtful of collection and charged as
expense during an accounting period.

Interest Expense. An expense related to use of borrowed

funds.

ACCOUNTING FOR BUSINESS TRANSACTIONS

- Accountants observe many events that they identify and

measure in financial terms.

Business transaction is the occurrence of an

event or a condition 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 - This sole proprietorship business is owned by

Dr. Rey Fernan Refozar, is also a CPA. The office is
managed by Jiexel Manongsong, CPA, MBA. The firm is
located in a large office complex that has easy public
access.

Refozar Accounting Services is a firm that

provides a wide range of bookkeeping and
accounting services.
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.
Note that the date of the transaction is
enclosed in parentheses. During October 2016,
the first month of operations, various financial
transactions took place.

Purchasing Equipment on Credit

Amounts that a business must pay in the future

under this agreement are known as accounts
payable.
The entities or individuals to whom the
amounts are owed are called creditors.