LESSON 2: BUSINESS TRANSACTIONS

AND THE ACCOUNTING CYCLE

 DEFINITION OF BUSINESS ACTIVITIES

Business activities are described in terms of

transactions and events.
• External transactions are exchanges of value
between two entities such as bank
borrowings, rendering of services to
customers or purchase of supplies with
suppliers.
• Internal transactions are exchanges with in the
entity such as the initial investment of the
 the owner, withdrawal by the owner or
payment of salaries to its employees.
• Events are happenings that affect an entity’s
accounting equation and can be measured
reliably. Examples are changes in the market
values of certain assets and liabilities and
natural event such as flood and fire that perish
assets and create losses to the company.
Examples of business transactions:
• Initial investment by the owners
• Purchase of office supplies for cash
• Acquisition of office and store equipment on
credit
• Payment for business and operating expenses
• Payment for accounts payable
• Rendering of services for cash
• Selling of goods on credit
• Collection of accounts receivable
• Cash withdrawal by the owners
 DEFINITION OF ACCOUNT
Account refers to record within an accounting
system in which increases and decreases are
entered and stored in specific asset, liability,
equity, revenue or expenses.
CLASSIFICATION OF ACCOUNT
• Asset accounts – are the resources owned or
controlled by an entity and that have expected
future benefits.
• Liability accounts – are claims by creditors
against assets. They are obligations to transfer
assets or provide products or services to other
entities.
• Equity accounts – owner’s claim on a company’s
assets. It represents the residual interest in the
assets of a business after deducting all the
liabilities.
STATEMENT OF FINANCIAL POSITION ACCOUNTS
These are considered real or permanent
accounts which are report on activities related
 to one or more future accounting periods and
carry ending balances into the next accounting
period. These accounts are not closed at the
end of the period. Examples:
• Assets
1. Cash and cash equivalents – include money,
checks and coins. Cash equivalents are short-
term investments that are readily convertible
into cash (maximum term is 90 days)
2. Investments – assets held by an entity for
the accretion of wealth through distribution
such as interest, dividends and rental,
royalties and for capital appreciation.
Examples are investment in stocks, investment
in debt securities and land held for capital
appreciation.
3. Accounts receivable – refer to promises of
payment from the customers to sellers arising
from rendering of services or selling of good
on credit.
4. Notes receivable – a written promise of an
entity to pay a definite sum of money on a
specified future date to the holder of the note.
5. Merchandise inventory – unsold finished
goods at the end of the period.
6. Prepaid expenses - prepayments of future
expenses such as prepaid rent and prepaid
insurance.
7. Unused store and office supplies – include
plastic and paper bags, cartons, packaging
 materials, stationery, paper, ball pens, pencil,
ink and toner.
8. Property, plant and equipment – includes
office equipment, store equipment, building,
office furniture and fixtures, land.
9. Intangible asset – includes goodwill, patent,
franchise, copyright, trademark, leasehold
and computer software.
• Liabilities
1. Accounts payable – refer to oral or implied
 promises to pay later from purchases of
supplies, merchandise, equipment or services.
2. Note payable – formal promise denoted by
signing of a promissory note to pay a future
account.
3. Unearned revenue – liability that is settled in
the future when a company delivers its
products or services. It is the income
received in advance but not yet earned as of
a given date.
4. Accrued expenses – expenses already incurred but not
yet paid as of a given date.
• Equity
1. Owner capital – owner’s investment in the company
2. Owner withdrawals – withdrawals by the owner
THE INCOME STATEMENT ACCOUNTS
These are referred to as temporary or nominal accounts
which accumulate data related to one accounting
period. They are accounts that are opened at the
beginning of a period, used to record transactions for
the period and then closed at the end of the period. The
closing process applies only to
 temporary or nominal accounts. Accounts
that are subjected to closing entries include
the income/revenue and expenses accounts,
withdrawal account and the Income and
Expense Summary Account. Examples are:
INCOME/REVENUE
• Service revenue – account used when the
company rendered services in cash or on
account/credit basis.
• Sales – account used when the company sell
merchandise in cash or on account/credit
basis.
• Gains – account used when the company sell
an asset for profit like gain on sale of
equipment and gain on sale of investment.
• Other income – miscellaneous income such as
interest income and dividend income.
EXPENSES: Operating expenses are classified
into 2 categories:
 1. Office or Administrative Expenses
• Office rent expense
• Office salaries expense
• Insurance expense
• Utility expense
• Depreciation expense of all furniture and
fixtures, equipment and office building
2. Selling Expenses
• Store rent expense
• Store salaries expense
• Advertising and promotion expense
• Depreciation of store furniture and fixtures,
store equipment, store building
• Store supplies
3. Other Expenses
• Losses- when the firm sell an asset at a loss
like loss on sale of equipment, and loss on
sale of investment
• Miscellaneous expenses – include bank
charges, purchase discount loss, interest
expense.
EFFECTS OF TRANSACTION IN THE
ACCOUNTING EQUATION
Specific business transactions have significant
effects on the accounting equation. For
example, DEF Co. has various transactions
during 2020, as follows:
Transaction No. Specific transaction
1 The owner made an initial
investment of P 500,000 cash
2 The owner made additional
investment of P 400,000
worth of office equipment.
3 Rendered services for cash
P 256,000.
4 Rendered services on account
P 400,000.
5 Purchase office furniture on
account, P 75,000.
6 Payment of salaries expense
P 120,000.
7 Owner withdrew cash
amounting to P 50,000.
8 Payment of accounts payable
related to transaction no. 5
9 Purchase of supplies for cash
P 35,000.
 The effects on the accounting equation are as
follows:
T# Assets Liabilities Equity
1 increase increase
2 increase increase
3 increase increase
4 increase increase
5 increase increase
6 decrease decrease
7 decrease decrease
8 decrease decrease
9 no effect on the accounting equation
CONCLUSIONS:
1. Assets increase when there are investments
by the owner/s in the form of cash and non-
cash assets, rendering of services for cash or
on account, and purchase of an asset for cash
or on account.
2. Assets decrease when there are withdrawals
by the owner, payment of expenses, cash
purchases of assets like property, plant and
equipment and investments, payment of
accounts payable and payment of accrued
expenses.
3. Liabilities increase when there is a purchase
of supplies, fixed assets on account and bank
borrowings. It also increases when there is
an accrual of business expenses and the
 receipt of unearned/deferred revenue.
4. Liabilities decrease when there is payment of
the accounts payable and other related
payable account and realization of unearned
deferred revenue.
5. Equity account increases when there is initial
and additional investment by the owner and
the sale of goods and services in cash or on
account.
6. Equity account decreases when the owner
 made withdrawals and incurring business
expenses.
THE NATURE OF DEBIT AND CREDIT
• The left side of the account is called the debit
side and is abbreviated as Dr.
• The right side is called credit side and is
abbreviated as Cr.
• A T-account represents a ledger account and is
a tool to understand the effects of one or
more transactions.
• The difference between the total debits and
total credits for an account including any
beginning balance is called account balance.
When the sum of debits exceeds the sum of
credits, the account has a debit balance. It
has a credit balance when the sum of the
credits exceeds the sum of debits.
• The double-entry accounting requires that
each transactions affect and be recorded in at
least 2 accounts. The total debits shall be
equal to the total credits for each transaction.
DEBIT AND CREDIT EFFECTS FOR COMPONENT
ACCOUNTS:
ASSETS – normal balance is debit
- debit for increases
- credit for decreases
LIABILITIES – normal balance is credit
- debit for decreases
- credit for increases
EQUITY – normal balance is credit
 - debit for decreases
- credit for increases
INCOME/REVENUE – normal balance is credit
- debit for decreases
- credit for increases
EXPENSES – normal balance is debit
- debit for increases
- credit for decreases
THE ACCOUNTING RECORDS OF A BUSINESS
ENTITY
1. Source documents – source of information
for accounting entries that can be either paper
or electronic form. The original source
materials evidencing a transaction. Examples
are official receipts, sales invoices, purchase
invoices, and debit and credit memorandum.
2. Book of original entry – refers to the journal
where transactions are recorded chronological
order. The general journal entry consists of a
 date, a folio, the accounts and the amount to
be debited and credited and a short
explanation of a transaction. Some companies
use special journals to record specific
transactions such as:
• Sales Journal – records only the sale of goods
• Purchase Journal – records the purchase of
merchandise on credit
• Cash Receipts Journal – records the receipt of
cash/cash inflows.
• Cash disbursements journal – records
payments in cash/cash outflows.
3. Books of final entry – the general and
subsidiary ledgers. The general ledger is a
record of information for each asset, liability,
equity, revenue and expense accounts while
the subsidiary ledger is a device used in
storing certain general ledger accounts such as
the accounts receivable and the accounts
payable.
TEN STEPS IN THE ACCOUNTING CYCLE

1. Analysis of business transactions - source

documents are analyzed by the accountant as
to impact of a given transaction on the asset,
liability, equity, revenue and expense
accounts.
2. Journalize – records transactions in
chronological order in the journal.
3. Posting – transfer debits and credits from the
journal to the ledger.
4. Prepare unadjusted trial balance –
summarize unadjusted ledger accounts and
amounts.
5. Prepare and post the adjusting entries –
record adjustments to bring account balances
up to date.
6. Prepare adjusted trial balance – summarize
adjusted ledger accounts and amounts.
7. Prepare the financial statements – use the
adjusted trial balance to prepare the basic
 financial statements.
8. Prepare and post closing entries – journalize
and post to close all temporary or nominal
accounts.
9. Prepare post-closing trial balance – to test
clerical accuracy of the closing procedures.
10.Prepare the reversing entries (optional) –
reverse certain adjustment in the next
accounting period which include accrual
revenue, accrual expense, unearned income
and prepaid expenses.