CHAPTER 4 – THE ACCOUNTING EQUIATION AND THE DOUBLE-ENTRY SYSTEM

ELEMENTS OF FINANCIAL STATEMENTS

Financial Position

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 resource controlled by the enterprise as a result of past events and from which future
economic benefits are expected to flow to the enterprise (per IFRS Framework). In simple terms, assets
are valuable resources owned by the entity. Assets include cash, cash equivalents, notes receivable,
accounts receivable, inventories prepaid expenses, property, plant and equipment, investments,
intangible assets and other assets.

Liability is a present obligation of the enterprise arising from past events, the settlement of which is
expected to result in an outflow from the enterprise of resources embodying economic benefits (per
IFRS Framework). A plain definition would be liabilities are obligations of the entity to outside parties
who have furnished resources. Liabilities include notes payable, accounts payable, accrued liabilities,
unearned revenues, mortgage payable, bonds payable and other debts of the enterprise.

Equity is the residual interest in the assets of the enterprise after deducting all its liabilities (per IFRS
Framework). 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, owners' equity, or shareholders' or stockholders' equity, consists of share capital or
capital stock, retained earnings and reserves representing appropriations of retained earnings among
others.

Performance

If there is an excess of revenue 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 revenue and expenses.

Income is increases in economic benefits during the accounting period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than those
relating to contributions from equity participants (per IFRS Framework).
The definition of income encompasses both revenue and gains. 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. Gains represent increases in economic benefits and as such
are no different in nature from revenue. Hence, they are not regarded as constituting a separate
element.

Expenses are decreases in economic benefits during the accounting period in the form of outflows or
depletions of assets or incurrences of liabilities that result in decreases in equity, other than those
relating to distributions to equity participants (per IFRS Framework).

The definition of expenses encompasses losses as well as those expenses that arise in the course of the
ordinary activities of the enterprise. There are various classes of expenses but they are generally
classified as cost of services rendered or cost of goods sold, distribution costs or selling expenses,
administrative expenses or other operating expenses.

Losses represent other items that meet the definition of expense and may may not, arise in the course
of the ordinary activities of an enterprise. Losses represent decreases in economic benefits and as such
are no different in nature from other expenses. Hence, they are not regarded as a separate element.

THE ACCOUNT

The basic summary device of accounting is the account. 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. 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 next page:

Account Title

Left side or Debit side | Right side or Credit side

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 residual interest in the
assets. It states that assets must always 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.

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.

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. (from the Latin
debere) and Cr. (from the Latin credere), 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.

The following summarizes the rules:

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

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. Owner's equity is the preferred term and is the term
used throughout this book.
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 of the 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.

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 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 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 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.
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.
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 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.

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 related benefits.

Telecommunications, Electricity, Fuel and Water Expenses. Expenses related to use of

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 number 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.

Reference:

Ballada, W. (2017). Fundamentals of Accountancy Business & Management 1. DomDane Publishers &
Made Easy Books.