PROF 07 –

FINANCIAL ACCOUNTING AND

REPORTING
Modularized Instructional Material

Prepared by:
Li-Anne M. Serrano, CPA
Instructor 1

BICOL UNIVERSITY
College of Business, Economics and Management
Department of Accountancy
Module 02: The Accounting Cycle
This module should help the students:
1. STATE the BASIC ACCOUNTING EQUATION and explain the meaning of
ASSETS, LIABILITIES, and OWNER’S EQUITY.
2. ANALYZE the effect of BUSINESS TRANSACTIONS on the basic
accounting equation.
3. DETERMINE the different FINANCIAL STATEMENTS.

Discussion:

The Accounting Equation

The basic accounting equation is:

Assets = Liabilities + Owner's Equity.

The accounting equation applies to all economic entities regardless of size, nature of
business, or form of business organization.

The key components of the basic accounting equation are:

a. Assets are resources controlled (not necessarily owned) by a business that
are necessary for the conduct of its activities.
b. Liabilities are claims against assets. These represent obligations that are
owed to third parties in the form of loans, payables, etc.
c. Owner's equity is the residual claims of owners against the assets. This
represents the remaining portion of the business that is retained by the
owner after the assets are used to settle the liabilities.

To understand this a little better, let’s consider that you want to create your own
business, i.e., a computer shop. In order to start the business, you would need cash,
a couple of computer units, chairs, internet connection, business space, and other
necessary equipment. These resources are the ASSETS of your business.
If you personally have the needed assets for your business, then you can right away
invest those assets into the business enterprise. By investing into the business, you,
as the owner now has a claim over the assets of the business. This claim is the
OWNER’S EQUITY.

IF you don’t personally have the needed assets, then you can borrow money from a
bank to buy the assets. The act of borrowing creates an obligation to a third party,
that is the obligation to pay back the money owed. This obligation is the LIABILITY.

So, in order to have assets in your business, you could either OWN (owner’s equity)
them already, or you could BORROW (liabilities) from other parties.
To summarize, look at the accounting equation again:

In proprietorships, there are four subdivisions of owner's equity:

a. Investments by Owner / Capital are the assets put in the business by the
owner.
b. Revenues are the gross increases in owner's equity resulting from business
activities entered into for the purpose of earning income.
c. Drawings are withdrawals of cash or other assets by the owner for personal
use.
d. Expenses are the cost of assets consumed or services used in the process of
earning revenue.

An expanded form of the accounting equation can be expressed as:

ASSETS = LIABILITIES + OWNER'S CAPITAL - OWNER'S DRAWING + REVENUES – EXPENSES

Revenues and expenses determine if a net income or net loss occurs as follows:
a. Revenues > Expenses = Net Income.
b. Revenues < Expenses = Net Loss.

Transactions
Transactions are the economic events of the enterprise recorded. Each transaction
must be analyzed in terms of its effect on the components of the basic accounting
equation. The analysis must also identify the specific items affected and the amount
of the change in each item.

Each transaction has a dual effect on the equation. For example, if an individual asset is
increased, there must be a corresponding:
a. decrease in another asset, or
b. increase in a specific liability, or
c. increase in owner's equity.

A tabular summary may be prepared to show the cumulative effect of transactions on

the basic accounting equation. The summary demonstrates that:
 a. Each transaction must be analyzed in terms of its effect on (1) the three
components of the equation and (2) specific types of items within each
component.
b. The two sides of the equation must always be equal.
c. The causes of each change in the owner's claim on assets must be indicated in
the owners' equity column.

Exercise
Recording transactions in transaction worksheet:
Lee Chang enjoys listening to all types of music and owns countless CDs. Over the
years, Lee has gained a local reputation for knowledge of music from classical to rap
and the ability to put together sets of recordings that appeal to all ages.

During the last several months, Lee served as a guest disc jockey on a local radio
station. In addition, Lee has entertained at several friends’ parties as the host deejay.

On June 1, 2010, Lee established a proprietorship known as Music Depot. Using an

extensive collection of music CDs, Lee will serve as a disc jockey on a fee basis for
weddings, college parties, and other events. During June, Lee entered into the
following transactions:

June 1 Deposited P8,000 in a checking account in the name of Music Depot.

June 2 Received P2,400 from a local radio station for serving as the guest disc jockey
for June.

June 3 Agreed to share office space with a local real estate agency, Upstairs Realty.
Music Depot will pay ¼ of the rent. In addition, Music Depot agreed to pay a
portion of the salary of the receptionist and to pay one-fourth of the utilities.
Paid P750 for the rent of the office.

June 4 Purchased supplies (blank CDs, poster board, extension cords, etc.) from City
Office Supply Co. for P350. Agreed to pay P100 within 10 days and the
remainder by July 5, 2010. June 6 Paid P600 to a local radio station to
advertise the services of Music Depot twice daily for two weeks.

June 8 Paid P500 to a local electronics store for renting digital recording equipment.

June 12 Paid P250 (music expense) to Cool Music for the use of its current music demos
to make various music sets.

June 13 Paid City Office Supply Co. P100 on account.

June 16 Received P400 from a dentist for providing two music sets for the dentist to
play for her patients.

June 22 Served as disk jockey for a wedding party. The father of the bride agreed to
pay P1,350 the 1st of July.

June 25 Received P500 from a friend for serving as the disc jockey for a cancer charity
 ball hosted by the local hospital.

June 29 Paid P240 (music expense) to Galaxy Music for the use of its library of music
demos.

June 30 Received P1,000 for serving as disc jockey for a local club’s monthly dance.

June 30 Paid Upstairs Realty P400 for Music Depot’s share of the receptionist’s salary for
June.

June 30 Paid Upstairs Realty P300 for Music Depot’s share of the utilities for June.

June 30 Determined that the cost of supplies on hand is P170. Therefore, the cost of
supplies used during the month was P180.

June 30 Paid for miscellaneous expenses, P150.

June 30 Paid P800 royalties (music expense) to National Music Clearing for use of
various artists’ music during the month.

June 30 Withdrew P200 of cash from Music Depot for personal use.

Indicate the effect of each transaction and the balances after each transaction in the
transaction worksheet.
Date Assets Liabilities Owner’s Equity

Capital Drawings Revenues Expenses

Sample:

June 1 + 8,000 +8,000

The assets and capital are increased because of the owner’s contribution of cash into
the business. Continue the table below:
Date Assets Liabilities Owner’s Equity

Capital Drawings Revenues Expenses

June 2

June 3

June 4

June 6

June 8

June 12
 June 13

June 16

June 22

June 25

June 29

June 30

June 30

June 30

June 30

June 30

June 30

June 30

The Financial Statements

Four financial statements are prepared from the summarized accounting data:
a. An income statement presents the revenues and expenses and resulting net
income (or net loss) for a specific period of time. It is also known as the
Statement of Financial Performance because it provides information about
the entity’s business activities (How did it do? Did it do good for the year?).
b. An owner's equity statement summarizes the changes in owner's equity for
a specific period of time.
c. A balance sheet reports the assets, liabilities, and owner's equity at a specific
date. It is also known as the Statement of Financial Position because it
provides information about the entity’s standing as to its resources (Where is
the business right now? Is it in a good financial position?).
d. A statement of cash flows summarizes information concerning the cash
inflows (receipts) and outflows (payments) for a specific period of time.

The financial statements are interrelated because:

a. Net income (or net loss) shown on the income statement is added
(subtracted) to (from) the beginning balance of owner's capital in the
 owner’s equity statement.
b. Owner's capital at the end of the reporting period shown in the owner’s equity
statement is reported in the balance sheet.
c. The amount of cash shown on the balance sheet is reported on the statement
of cash flows.

A more detailed discussion on the preparation of financial statements will be

presented in the next modules.