DETAILED LEARNING MODULE

Title: ACCOUNTING EQUATION AND DOUBLE-ENTRY BOOKKEEPING

SYSTEM

Module No. 2

I. Learning Objectives
After studying this chapter, students should be able to:
1. Describe the accounting information system in a broader perspective.
2. Explain how the accounting information system helps the decision makers.
3. Identify and understand the nature of the accounting elements and its uses.
4. Recognize how the elements affect the accounting equation as applied to
all types of businesses.
5. Analyze business transactions from source documents using the accounting
equation and financial transaction worksheet.
6. Apply knowledge of the accounting equation to better understand the rules
of debits and credits for recording purposes.
.

II. Topics and Key Concepts

ACCOUNTING INFORMATION SYSTEMS

• With the employment of technology brought about by business
globalization, providing and processing of financial information
becomes a “click of a finger”. Though the effectiveness of the
system largely depends on the nature, size of the business and
volume of data to process, yet accounting information systems
made businesses cope up with the fast demands of accounting
information and transactions. While accounting information
involves planning, recording, analyzing and interpreting data, it
needs to gather and process it and then distributes this information
to interested end-users.
• A collection of people, procedures, software, hardware, and data
which work together to provide information necessary to running
an organization
 Accounting information Cycle

Stages of Accounting Information System

The accounting information system comprises of three (3) stages as follows:

Stage 1 – Inputs
The collection of raw data, acquired from internal and external sources,
evidenced by source documents such as invoices, receipts, contracts, etc.

Stage 2 – Process
Refers to data processing which includes sorting , classifying and summarizing
function into their respective files and categories, storing them in their
respective records.

Stage 3 - Outputs
The generation of financial reports and communication of the needed
information to the decision makers or end-users.

Types of accounting information system

1. Manual accounting system – utilize paper-based journals and

ledgers, the whole process is done manually. This is labor intensive
and dependent on human processing.
 2. Computer-based system – uses modern information technology
resources and transactions are coded and can be quickly posted
bypassing the journalizing process. It replaced paper records with
computer records.

3. Database system – it embeds accounting data within the business

event data on which they are based. It reduces inefficiencies and
redundancies that often exist in a transaction -based systems. The
computer, with the use of accounting software processes the inputs.
This system recognizes and capture both financial and nonfinancial
data and store it in a data warehouse.

ELEMENTS OF FINANCIAL STATEMENTS

The broad classification of business transactions in the financial statements are called accounting
elements.

As defined in March 2018 Conceptual Framework for Financial Reporting, these

elements of financial statements are:
1. Assets
2. Liabilities
3. Equity
4. Income
5. Expenses

ASSETS
The term “assets” refers to the resources controlled by the entity as a result of past events
and from which future economic benefits are expected to flow to the entity.
• In simple terms, assets are properties owned and controlled by the business.
• An economic resource is a right that has potential to produce economic
benefits for the entity which has the sole control or ability to prevent other
parties to direct the use of that economic resource.

LIABILITIES
The term “liabilities” refers to the present obligations of an entity arising from
past events, the settlement of which is expected to result in an outflow from the
entity of resources embodying economic benefits.
• Simply stated, liabilities are the debts incurred by the business for the
transfer of an economic resource as a result of past events.
• An obligation of the entity, owed to another party

EQUITY
• The term “equity” refers to the residual interest in the assets of the entity after
deducting all its liabilities.
 • Equity represents owner’s capital and what is left to the owner after deducting
the entity’s debts or obligation.
• It represents claim of the owner/s over the assets of the business in the form
of capital.

NOTE: Assets, liabilities and equity – relate to a reporting entity’s financial

position (shown in the Statement of Financial Position or
Balance Sheet)

INCOME
• The term “income” refers to the increase in economic benefits during the
accounting period in the form of inflow or enhancement of assets or decrease of
liabilities resulting in an increase in equity other than those relating to equity
claims from equity participants or equity contributors.
• The basic accounting principle is that income increases the equity of the owners
while loss decreases the owner’s equity.

EXPENSES
• The term “expenses” refers to decreases in economic benefits during the accounting period
in the form of outflow or depletion of assets or incurrence of liabilities that result in
decreases in equity other than those relating to equity claims from equity participants or
equity contributors.
• The basic accounting principle is that expenses decrease the equity of the owners.

NOTE: Income and expenses – relate to a reporting entity’s financial performance (shown
in the Statement of Comprehensive Income or Income Statement).

ACCOUNTING EQUATION
The most basic tool of accounting is the accounting equation. This equation presents the
resources controlled by the enterprise, the present obligation of the enterprise, and the residual
interest in the assets as shown in this model.

Basic Accounting Model

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 transaction affects at least two accounts.
The total debits for a transaction must always equal the total credits.

Debit (Dr.) The place of debit is the left-hand side of the accounting
equation therefore an account is debited when it is entered in the
left side of the T-Account.
Credit (Cr.) The place of credit is on the right-hand side of the accounting
equation therefore the account is credited when it is entered on
the right side.

To better understand the debits and credits, a T-Account is used.

It is called such because it resembles a big letter T, used to summarize
and determine account balances without the need for the formal ledger.
The T-Account has three (3) parts: the account title, the debit and the
credit side.

The T-Account

Rules of Debits and Credits

The rules of debits and credits depend on the account type and how increases
or decreases in it are recorded. This increase-decrease effect should be
expressed in the technical parlance of accounting which is to debit and
to credit as it affects all the accounting elements.

A. For the elements of financial position (Assets, Liabilities,

Owner’s Equity), the following rules apply:
• Increases in assets are recorded as debits (left side), while
decreases in assets are recorded as credits (right side). •
Increases in liabilities and owner’s equity are recorded as
credits (right side) decreases are entered as debits (left
side)

B. For the elements of financial performance (Income and

Expenses), the rules of debits and credits 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 (right
side) and decreases are recorded as debits (left side).
• Increases in expenses are recorded as debits (left side)
and decreases are recorded as credits (right side)

Figure below summarizes the rules of debits and credits. It shows the
effects of transactions to the elements of financial statements in terms of
increases and decreases.

The Normal Balance of an Account

The normal balance of an account refers to the side of the account,
debit or credit, where increases are recorded.
• Assets, Owner’s withdrawals, and Expenses increases on the
debit side therefore the normal balance of these accounts is a debit.
• Liability, Owner’s Capital, and Income accounts increases on
the credit side therefore the normal balance of these accounts is a
credit.
 Accounting Events and Transactions
An accounting event is an economic occurrence that causes
changes in an entity’s assets, liabilities, and/or equity. It can be an
internal event such as the use of equipment to produce goods or services
or an external event such as the purchase of raw materials from a
supplier. A business transaction is a particular kind of event that involves
the transfer of something of value between two parties such as
purchasing and selling of goods or services and borrowing funds from
creditors and that it can be reliably recorded.

Types and Effects of Transactions

It is beneficial in the recording process that transactions are
analyzed relative to their effects to the different accounting elements
rather than the recording involved. We call this classification approach.
All business transactions can be classified into one of four types namely:

1. Source of Assets (SA). An asset account increases and a

corresponding claim (liabilities or owner’s equity) account
increases.
• Examples: Purchase supplies on account.
Sold goods on cash on delivery basis.

2. Exchange of Assets (EA). One asset account increase and

another asset account decrease.
Example: Acquired equipment for cash.

3. Use of Assets (UA). An asset account decreases and

corresponding claims (liabilities or equity) account decreases.
Examples: Settled accounts payable.
Paid salaries of employees.

4. Exchange of Claims (EC). One claim (liabilities or owner’s

equity) account increases and another claims (liabilities or
owner’s equity) account decreases. Examples: Received
utilities bill but did not pay.

TYPICAL ACCOUNT TITLES USED

Statement of Financial Position

Assets. As per revised Philippine Accounting Standards (PAS) No. 1,

assets should be classified only in two (2): Current and Non-Current
Assets. Assets are considered current when:
 a. it expects to realize, consumes or intends to sell it within the
normal operating cycle of the business
b. it holds the asset primarily for the purpose of trading
c. it expects to realize the asset within twelve (12) months after the
reporting period
d. the asset is cash or cash equivalent (as defined in PAS No.7),
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. When
the entity’s normal operating cycle is not clearly identifiable, it is
assumed to be twelve (12) months. The entity uses an accounting
period that covers certain accounting functions which can be either
a calendar or fiscal year.

Calendar year means the accounting operations of the business

covers one year from January and ends in December.

Fiscal year or period means any 12-month period covering the

accounting operations of the business.
Example: May 2019 to May 2020 is one fiscal period.

CURRENT ASSETS
Cash It refers to any medium of exchange that a bank will accept
for deposit at face value including coins, currency, checks,
money orders, bank deposits and drafts.
Cash Per PAS No. 7, these are short-term , highly liquid investments that
Equivalents are readily convertible to known amount of cash and which are
subject to insignificant risk of changes in value

Notes A written pledge that the customer will pay the business a fixed
Receivable amount of money on a certain date.

Accounts These are claims against customers arising from sale of

Receivable services or goods on credit. This type of receivable offers
less security than a promissory note.

Allowance for A contra-asset account which provides for possible losses

Uncollectible from uncollected accounts receivable. The amount provided
accounts for this is only an estimate.
/Bad debts
 Inventories Per PAS No. 2, these are assets (a) which are 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
classified as an asset because the business avoids having to pay cash
in the future for a specific expense.

NONCURRENT ASSETS
Property, Per PAS No. 16, these are tangible assets that are held by an
Plant & enterprise for use in the production or supply of goods or
Equipment services, or for rental to others, or for administrative purposes
and which are expected to be used during more than one period.
Examples: Land, Machinery, Equipment, furniture and fixtures.

Accumulated It is a contra-account that contains the sum of the periodic

Depreciation. depreciation charges. The balance from this account is
deducted from th cost of the related asset – equipment or
building – to obtain book value.

Intangible Assets Per PAS No. 38, these are identifiable non monetary assets
without physical substance held for use in the production or
supply of goods or services, for rental to others, or for
administrative purposes.
Examples: Goodwill, patents, copyrights, licenses, franchises,
trademarks, brand names, secret processes,
subscription lists and on-competitive agreements.

LIABILITIES
Current Liabilities. As per revised PAS No 1, an entity shall classify 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 (12) months after the reporting
period.
d. the entity does not have an unconditional right to defer settlement of the
liability for at least twelve months after the reporting period.
 CURRENT LIABILITIES
Accounts Payable It denotes obligations or debts of the business arising
from services received, merchandise,
supplies or property, plant and equipment
acquired on account. It is an “open account”
obligation because it is not supported by a
promissory note.

Notes Payable The treatment is similar to accounts payable however,

this account is supported with a promissory note
executed by the debtor in favor of the creditor
Accrued liabilities Amounts owed to others for unpaid expenses. This
account includes salaries payable, utilities payable,
interest payable and taxes payable

Unearned The business entity receives payment before

Revenues providing the customers with goods or services, the
amount received is reorder to unearned revenue
account. When the goods or services are provided to
the customer, the unearned revenue account is
reduced and income is recognized.

Current Portion of Long- These are portion of mortgage notes, bonds and other
term Debt long-term indebtedness which are to be paid within
one year from the balance sheet date.

NONCURRENT LIABILITIES
Mortgage Payable This account is used to record long-term debt that is
supported or backed up by a collateral or has pledged
certain assets as security to the creditor.

Bonds Payable Is a contract between the issuer and the lender

specifying the terms and conditions of repayment
and the amount of interest to be charged. It is a long-
term obligation evidenced by certificate of
indebtedness. Business obtain funds to finance
acquisition of equipment and other needed assets by
issuing bonds.
EQUITY. The equity represents what is left to the business after the liabilities are fully
paid.
EQUITY
Capital This account is used to record the original and
additional investments of the owner of the business.
It is increased by the amount of profit earned during
the year or decreased by a loss or by cash or other
assets that the owner may withdraw from the
business. This account bears the name of the owner.

Income Summary Is a temporary account used at the end of accounting period

to close income and expenses.This account shows the profit
or loss for the period before closing to the capital account.

Withdrawals When the owner of a business entity withdraws cash

or other assets for personal use, such is recorded in
the withdrawal account rather than directly reducing
the owner’s equity account.

STATEMENT OF COMPREHENSIVE INCOME

INCOME- Increases in economic benefits during the accounting period in the

form of inflows and enhancement of assets. The definition of income
encompasses both revenue and gains. Though these terms are almost similar,,
however, there is a distinct technical difference between them.

Service Income-Revenues earned by performing services

for a customer or client. .

Sales-Revenues earned as a result of sale of merchandise.

EXPENSES- A decrease in economic benefits during the accounting period as

a result of outflows or depletion of assets.

EXPENSES

Cost of Sales The cost incurred to purchase or produce the products sold to the
customers during the period. It is also known as the cost of goods
sold.
 Salaries and Wages All payments that arise from services from workers/
Expense. employees in an employee-employer relationship. It
includes salaries and wages, 13th month pay, cost of living
allowances and other related benefits.

Rent Expense Expense for renting a space, equipment or other asset rental.

Supplies expense Expense of using supplies like office supplies, in the conduct of
daily business.

Insurance Expense Portion of premium paid on insurance coverage which has

expired.

Depreciation Expense That portion of the cost of tangible asset (e.g. buildings
and equipment) allotted or charged to expense during the
accounting period. All tangible assets depreciate except
Land.

Uncollectible Accounts or It is the amount of receivables estimated to be doubtful of collection

Bad Debts Expense and charged to expense during the accounting period.

Interest Expense An expense related to use of borrowed funds

The list of accounts mentioned and discussed are typical accounts used in introductory
accounting. As you move to higher accounting subjects, new account titles will be
introduced.

Teaching and Learning Materials and Resources

Basic Financial Accounting and Reporting by WIN Ballada, CPA,CBE, MBA