ACCOUNTING FUNDAMENTALS

CHAPTER 3
The Accounting Equation and the Double-Entry System

The starting point in the accounting process is an analysis of the transactions

of a business. A business transaction is any financial that changes the
resources of a firm. For example, purchases, sales, payments and receipt of
cash are all 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 how
the accountant analyzes business transactions.

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. Examples of transactions include
acquiring assets from owner(s), borrowing funds from creditors, and
purchasing or selling goods and services.

ACCOUNTING INFORMATION SYSTEM

Every business organization must have an accounting information system which
will generate reliable financial information needed by the decision-makers in a
timely manner. 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 design of the system to meet the entity’s information
requirement depends on the firm’s size, nature of operations, volume of
transaction data, organizational structure, form of business and extent of

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ACCOUNTING FUNDAMENTALS

government regulation. These will influence the way in which information is

accumulated and reported in the financial statements.

An accounting information system is the combination of personnel, records and

procedures that a business uses to meet its need for financial information.
Most firms have an accounting manual that specifies the policies and
procedures to be followed in accumulating information within the accounting
information system. The manual details what events are to be recorded in the
accounts, and when and how the information is to be classified and
accumulated. An effective accounting information system should achieve the
following objectives:

 To process the information efficiently at eh least cost (cost-benefit

principle).
 To protect entity’s assets, to ensure that data are reliable, and to
minimize wastes and the possibility of theft or fraud (control principle).
 To be in harmony with the entity’s organizational and human factors
(compatibility principle).
 To be able to accommodate growth in the volume of transactions and for
organizational changes (flexibility principle).

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ACCOUNTING FUNDAMENTALS

The diagram illustrates how economic activities flow into the accounting
process, which produces accounting information. This information is then
used by decision makers in making economic decisions and taking specific
actions; thus, resulting in economic activities. The cycle goes on.

ELEMENTS OF FINANCIAL STATEMENTS

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 present economic resource controlled by the entity as a result of

past events. An economic resource is a right that has the potential to produce
economic benefits (per March 2018 Conceptual Framework for Financial
Reporting). There are three aspects to these definitions: ―right‖; ―potential to
produce economic benefits‖ and ―control‖.

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ACCOUNTING FUNDAMENTALS

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:
a) the entity has an obligation;
b) the obligation is to transfer an economic resource; and
c) the obligation is a present obligation that exists as a result of past events
Equity is the residual interest in the assets of the enterprise after deducting all
its liabilities. In other words, 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 because
there is only one owner.
 In a partnership, an owner’s equity account exists for each partner.
 In a corporation, owner’s equity or stockholders’ equity consists of share
capital, retained earnings and reserve representing appropriations of
retained earnings among others.

Financial Performance
If there is an excess of income 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 income and expenses.

Income is increases in assets, or decreases in liabilities, that result in

increases in equity, other than those relating to contributions from holders of
equity claims.

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ACCOUNTING FUNDAMENTALS

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.

It follows from these definitions of income and expenses that contributions that
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. Users of financial statements need information
about both an entity’s financial position and its financial performance. Hence,
although income and expenses are defined in terms of changes in assets and
liabilities, information about income and expenses is just as important as
information about assets and liabilities.

TYPICAL ACCOUNT TITLES USED

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.

Assets
Assets should be classified only into two: current assets and non-current
assets. An entity shall classify an asset as 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 end
reporting period; or
d) the asset is cash or a cash equivalent unless it is restricted from being
exchanged or used to settle a liability for at least twelve months after the
end of the reporting period.

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ACCOUNTING FUNDAMENTALS

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 as
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, Plant 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.

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ACCOUNTING FUNDAMENTALS

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.

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.

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ACCOUNTING FUNDAMENTALS

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 bond is a contract
between the issuer and the lender specifying the terms of repayment and the
interest to be charged.

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.

INCOME STATEMENT

Income
Revenue, or income, is the inflow of money or other assets (including claims to
money, such as sale made on credit) that results from sales of goods or services
or from the use of money or property. The result of revenue is an increase in
assets.

Service Income. Revenues earned by performing services for a customer or

client; for example, accounting services by a CPA firm, laundry services by a
laundry shop.

Sales. Revenues earned as a result of sale of merchandise; for example, sale of

building materials by a construction supplies firm.

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ACCOUNTING FUNDAMENTALS

Expenses
An expense involves the outflow of money, the use of other assets, or the
incurring of a liability. Expenses include the costs of any materials, labor,
supplies, and services used in an effort to produce revenue.

Cost of Sales. The cost incurred to purchase or to produce the products sold
to customers during the period; also called cost of goods sold.

Salaries or Wages Expense. Includes all payments as a result of an employer-

employee relationship such as salaries or wages, 13th month pay, cost of living
allowances and other related benefits.

Telecommunications, Electricity, Fuel and Water Expenses. Expenses

related to use of telecommunications facilities, consumption of electricity, fuel
and water.

Supplies Expense. Expense of using supplies (e.g. office supplies) in the

conduct of daily business.

Rent Expense. Expense for space, equipment or other asset rentals.

Insurance Expense. Portion of premiums paid on insurance coverage (e.g. on

motor vehicle, health, life, fire, typhoon or flood) which has expired.

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.

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

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ACCOUNTING FUNDAMENTALS

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

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.

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 financial position and can be reliably recorded.

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ACCOUNTING FUNDAMENTALS

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.

THE ACCOUNT
The accounting equation is a tool for analyzing the effects of business
transactions. It would be awkward, though, to record every transaction in the
equation format if a business had many transactions. Instead, separate written
records called accounts are kept. The account is the basic summary device of
accounting. 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. Accounts are kept so that financial information
can be analyzed, recorded, classified, summarized, and reported.

Use of T-Accounts
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 below:

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ACCOUNTING FUNDAMENTALS

DEBITS AND CREDITS - THE DOUBLE-ENTRY SYSTEM

Accounting is based on a double-entry system which means that the dual effect
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. 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. and Cr. 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.

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

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ACCOUNTING FUNDAMENTALS

accounts normally have credit balances. This result occurs because increases
in an account are usually greater than or equal to decreases.

Increases Recorded by Normal Balance

Account Category Debit Credit Debit Credit
Assets  
Liabilities  
Owner’s Equity:
Owner’s Capital  
Withdrawals  
Income  
Expenses  

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‖:

This Year
Transaction Amount Cash Receipts Sales Revenue
Cash sales made this year. 200,000 200,000 200,000
Credit sales made last year; 300,000 300,000 0
cash received this year.
Credit sales made this year; 400,000 400,000 400,000
cash received this year.
Credit sales made this year; 100,000 0 100,000
cash to be received next year
Total 900,000 700,000

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ACCOUNTING FUNDAMENTALS

EFFECTS 0F TRANSACTIONS
It will be beneficial in the long-term to be able to understand a classification
approach that emphasizes the effects of accounting events rather than the
recording procedures involved.

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 nine types of effects of transactions are as
follows:

1. Increase in Asset = Increase in Liability

2. Increase in Asset = Increase in Owner’s Equity
3. Increase in one Asset = Decrease in another Asset
4. Decrease in Asset = Decrease in Liability
5. Decrease in Asset = Decrease in Owner's Equity
6. Increase in Liability = Decrease in Owner's Equity
7. Increase in Owner’s Equity = Decrease in Liability
8. Increase in one Liability = Decrease in another Liability
9. Increase in one Owner's Equity = Decrease in another Owner's Equity

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