Fundamentals of Accountancy,

Business and Management 1

Module 5 & 6
The Accounting Concept, Principle and
Equation
The Five Major Accounts &
The Chart of Accounts

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 At the end of this lesson, the learners will be able
 Explain and identify the varied accounting concepts and principles;
 equate assets with liabilities and equity;
 perform operations involving simple cases with the use of accounting equation;
and
 solve problems using the accounting equation.

OVERVIEW

Sometimes we want to determine our performance compared to similar companies,

however, since there are a lot of ways and assumptions to present financial reports, we need to
have a generally accepted rule for accounting. The purpose of this lesson is for you to be able to
identify the different concepts and principles of accounting and identify if a specific situation
follows or violates an accounting principle. We will also discuss the definition and application of
the basic accounting equation in providing the information needed by the end-users in making
economic decisions.

Concept - an idea or invention to help sell or publicize a commodity.

Principle - a fundamental truth or proposition that serves as the foundation for a
system of belief or behavior or for a chain of reasoning. .
Equity - is the residual interest of the owner of the business. Meaning, any assets left after
paying
liabilities is the right of the owner of the business

Let us see how much you already know about the concept, principle and equation of accounting
by answering the pre-test.

Prelimenary Test
Instructions: Identify the principles described in the following items. Write your answer
on the space provided.

____________1. This principle relates to the significance of a transaction, balances and

errors in the financial information statements.
_____________2. This principle give guidance on how to record uncertain events and estimates.
_____________3. This principle requires assets to be valued and recorded based on the actual
cash equivalent
_____________4. Under this principle, cost should be matched with the revenue generated.
_____________5. In this principle the company should report all relevant information.

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Read the Information Sheet very well then find out how much you can remember and
how much you learned by doing the exercises.

Module 5.1 BASIC ACCOUNTING CONCEPTS and PRINCIPLES

Basic Accounting Concepts

1. Accounting Entity Concepts - This concept state that transactions related with a business
must be separated with the personal transactions of the owners. A separate recording must
be maintained to set a clear distinction between business transactions and personal
transactions. Doing so will help determine whether the business is profitable or not.
2. Going concern or Continuity Concept - This concept states that the business is assumed
to have a continuous life of existence. In other words, the business should be treated as if
they will continue to operate in a foreseeable future. It is assumed that the entity will settle
their obligations in the normal cycle of the business.
3. Time Period or Periodicity Concept -This concept states that business can divide up
their activities into time period that allow the financial statements to be prepared on a
monthly, quarterly and annual basis.
4. Unit of Measure or Monetary Measurement Concept - This concept states that all
business are recorded in terms of money. Transaction which cannot be expressed in terms
of money are not recorded in the books of accounts

BASIC ACCOUNTING PRINCIPLE

1. Cost principle - This principle requires assets to be valued and recorded based on the
actual cash equivalent at the time that an asset is acquired.
2. Full Disclosure Principle - This is the concept that all the necessary information that
would make a difference on the understanding of financial users should be disclosed in
the notes to financial statements.
3. Matching Principle - Under this principle, cost should be matched with the revenue
generated.
4. Materiality Principle- This principle relates to the significance of a transaction,
balances and errors in the financial information statements. It defines the cut-off point
after which financial information becomes relevant to the needs of the users.
5. Conservatism or Prudence Principle - This principle give guidance on how to record
uncertain events and estimates.
6. Business Entity Principle - a business enterprise is separate and distinct from its
owner or investor.
7. Going Concern Principle – business is expected to continue indefinitely.
8. Time Period Principle – financial statements are to be divided into specific time
intervals.
9. Monetary unit principle – amounts are stated into a single monetary unit.
10. Objectivity Principle – financial statements must be presented with supporting
evidence.

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 Module 5. 2 The Accounting Equation

What is Accounting Equation?

An Accounting Equation shows the relationship of the major accounts of accounting namely
Assets, Liabilities, Equity, Income and Expenses. It can be expressed by using either the basic
accounting equation or the expanded accounting equation. The basic accounting equation shows
the relationship between assets, liabilities and equity, to wit:

On the left side of the equation are the assets which refer to the resource owned by the entity.
On the right side are the claims over the assets which are divided into two types:
1. Liabilities or the rights of the creditor and
2. Equity or the rights of the owner.
This equation allows the end-users to determine the portion of the assets subject to claim of the
creditors and amount accruing to the owner. If the least two amounts in the accounting are given,
the third unknown amount can be easily computed.

Illustration of the effects of the transaction in the accounting elements

 Assets invested by the owner
July 1 - Paolo Reyes started a delivery service on July 1, 2013. The following transactions
occurred during the month of July. He invested PHP800,000 cash and Cars amounting to
PHP200,000.

 Borrowings from the bank

July 2 – Reyes borrowed PHP100,000 cash from PNB for use in his business.

 Asset purchased for cash

July 7 – Bought tables and chairs from Orocan and paid PHP45,000 cash

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 Assets purchased on account
July 15 – Various equipment were purchased on account from Fortune for PHP55,000

 Cash withdrawal by the owner

July 18 – Reyes made a cash withdrawal of PHP5,000 for personal use

 Payment of liability
July 20 – The account due to Fortune was paid in cash

The following table summarizes the effects of these transactions on the accounting equation

Determining profit through operation

• Accrual basis of accounting vs Cash basis of accounting – accrual basis recognizes
revenue when earned and recognizes expenses when incurred

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 • Under the expense recognition principle, expenses can be recognized either as:
(1) matching; (2) systematic allocation, or; (3) direct association.
• Profit measures the performance of the company. If the revenue exceeds expenses, then it
is a net profit; otherwise, it is a net loss.
Received cash for revenue earned
July 21 – A customer hired the services of Reyes. Cash of PHP15,000 was received from
the customers.

Paid cash for expenses incurred

July 22 – Cash was paid for the following : gas and oil, PHP500 and car repairs, PHP1,000.

Revenue rendered on account

July 24 – Another customer hired the services of Reyes and promised to pay PHP16,000 on July
31.

Paid for expenses incurred

July 25 – Paid PHP500 for telephone bill.

Revenue earned with a down payment, balance on account

July 27 – Another customer hired the services of Reyes. A bill was issued to them for PHP20,000,
50% of which was collected.

Customer’s account collected in cash

July 30 – The customer on July 24 paid 50% of his account in cash.

Paid cash for expenses incurred

July 31 – Paid PHP10,000 for rental of office space, and salaries of PHP9,000

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 The Expanded Accounting Equation
The basic accounting equation emphasizes only the relationship between the assets, liabilities
and equity. The relation of the other two accounts: income and expense cannot be decoded in the
basic form. In order to show the relationship of all major accounts, the accounting equation can be
expanded into another equation by breaking up the equity account, to wit:
Assets = Liabilities + ( Capital – Drawing + Income – Expenses)

The expanded accounting equation is focus on the breakdown of the equity. Capital increases
the equity since it represents the amount invested by the owner in the business. On the other hand,
Drawing is deducted since it represents the capital withdrawn by the owner from the business.
Logically, income increases equity because it improves the worth of the business while expenses
decrease equity because it refers to the resources given up to earn income.
Both income and expense are measures of financial performance of the entity. It gives the
end-user information on whether the business is still earning or already incurring losses. This can
be identified by deducting the expenses from income. If income is greater than the expense, there
is a net income, which is general indication of a favorable financial performance. Conversely, if
expense is greater than income then there is net loss, which is a general indication of an
unfavorable financial performance of the business. If income equals the expenses, it is called
breakeven which is neither a net income nor loss. In summary,

Net Income Income > Expense

Net Loss Income < Expenses
Breakeven Income = Expenses

Illustration: 1 2 3___
Income 5,000 1,000 3,500
Less: Expenses 3,000 2,000 3,500
Net Income (Loss) 2,000 (1,000) -0-
In the first situation, there is a net income of 2,000 since income is greater than the expense.
The second situation is a net loss of 1,000 since the expense is greater than the income. The third
situation is called breakeven since income is equal to expense.

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 Exercises

A. Instructions: Read the questions carefully and encircle the letter of the correct answer

1. The accounting guideline that requires financial statement information to be supported by

independent, unbiased evidence other than someone's belief or opinion is the:
A. Business entity principle C. Going-concern principle
B. Monetary unit principle D. Objectivity principle
2. The principle that requires every business to be accounted for separately and distinctly
from its owner or owners is known as the:
A. Business entity principle C. Going-concern principle
B. Revenue recognition principle D. Objectivity principle
3. The rule that requires financial statements to reflect the assumption that the business will
continue operating instead of being closed or sold, unless evidence shows that it will not
continue, is the:
A. Business entity principle C. Going-concern principle
B. Monetary unit principle D. Objectivity principle
4. To include the personal assets and transactions of a business's owner in the records and
reports of the business would be in conflict with the:
A. Business entity principle C. Going-concern principle
B. Realization principle D. Revenue recognition principle
5. The objectivity principle:
A. means that information is supported by independent, unbiased evidence
B. means that information can be based on what the preparer thinks is true
C. means that financial statements should contain information that is optimistic
D. means that a business may not re-organize revenue until cash is received
6. It shows the relationship between a company’s assets, liabilities, and capital.
A. Assets C. Owner’s Equity
B. Liabilities D. Accounting Equation
7. This refers to the economic resources owned by the company.
A. Assets C. Owner’s Equity
B. Liabilities D. Accounting Equation

8. This refers to the property and rights owned by the business.

A. Assets C. Owner’s Equity
B. Liabilities D. Accounting Equation
9. This refers to the investment of an owner.
A. Assets C. Owner’s Equity
B. Liabilities D. Accounting Equation
10. These include claims of the creditors on the assets of the company.
A. Assets C. Owner’s Equity
B. Liabilities D. Accounting Equation

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A. Directions: Fill in the missing amount in the table below using the Accounting Equations:

No Assets = Liabilities + Equity

.
1. = 60,000 + 40,000
2. 50,000 = + 20,000
3. 40.000 = 30,000 +
4. 3,000 = + 3,000
5. = 5,000 + 6,000
6. 20,000 = 4,000 +
7. = 17,000 + 4,000
8. 12,000 = 9,000 +
9. 6,500 = + 6,500
10. 5,000 = 5,000 +

B. Fill in the missing amount in computing Net Income (Loss)

1 2 3 4 5_____
Revenue 13,000 3,500

Expenses 2,000 2,750 6,5000 4,500____

Net Income (Loss) 4,000 2,000 0

3,000____

6 7 8 9 10_____
Revenue 6,000 2,500 3,750

Expenses 10,000 3,500 ___ 7,500___

Net Income (Loss) _(8,650) (4,560) 1,750 7,500 ___

References :

Wild, J. (2009). Principles of Accounting 19th Ed. McGraw Hill Publishing.

Haddocl, M., Proce, J., & Farina, M. (2012). College Accounting: A Contemporary Approach, 2nd
Fundamentals of Accountancy, Business and Management 1 : Julie Ann E. Lubon-Madelo, CPA,
MBA, Rommel E. Lubon, CPA, MBA.

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