Accounting Equation and the

Double-Entry System
Elements of financial statements
I. Financial position
A. 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.
B. Liability – is a present obligation of the entity to transfer an economic resource
as a result of past events. An obligation is a duty or responsibility that the entity
has no practical ability to avoid.
C. Equity – the residual interest in the assets of the entity after deducting all its
liabilities.
Elements of financial statements
I. Financial position
A. 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.
B. Liability – is a present obligation of the entity to transfer an economic resource
as a result of past events. An obligation is a duty or responsibility that the entity
has no practical ability to avoid.
C. Equity – the residual interest in the assets of the entity after deducting all its
liabilities.
Elements of financial statements
II. Financial performance
A. 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.
B. 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.
Assets
Assets may be classified into current assets and noncurrent 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.
d. The asset is cash or a cash equivalent unless it is restricted from being exchanged or
use to settle a liability for at least twelve months after the end of the reporting period.
An entity shall classify all other assets as noncurrent.
Current assets
The following are the common current assets of most businesses:
I. Cash
II. Cash equivalents – Short-term, highly liquid investments that are readily convertible to known
amounts of cash and which are subject to insignificant risk of changes in value.
III. Accounts receivable – Claims against customers arising from sale of services or goods on credit.
IV. Notes receivable – Written pledge that the customer will pay the business a fixed amount of
money on a certain date.
V. Inventories – Assets which are held for sale in the ordinary course of business; in the process of
production for such sale; or in the form of materials or supplies to be consumed in the
production process or in the rendering services.
VI. Prepaid expenses – Expenses paid for by the business in advance.
Noncurrent assets
The following are the common noncurrent assets of most businesses:
I. Property, plant and equipment – 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.
II. Accumulated depreciation – A contra account that contains the sum of the periodic
depreciation charges of property, plant and equipment.
III. Intangible assets – 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.
Liabilities
Liabilities may be classified into current liabilities and noncurrent 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.
d. The entity does not have an unconditional right to defer settle of the liability for at
least twelve months after the end of reporting period.
An entity shall classify all other liabilities as noncurrent.
Current liabilities
The following are the common current liabilities of most businesses:
I. Accounts payable – Obligations to suppliers arising from purchase of services or goods
on credit.
II. Notes payable – Reverse of note receivable.
III. Accrued liabilities – Amounts owed to others for unpaid expenses such as salaries
payable, utilities payable, interest payable and taxes payable.
IV. Unearned revenues – Obligations to perform services or deliver goods that are paid in
advance.
V. Current portion of long-term debt – Portion of long-term debts which are to be paid
within one year at the end of reporting period.
Current liabilities
The following are the common noncurrent liabilities of most businesses:
I. Mortgage payable – Long-term debt of the business for which the business has
pledge3d certain assets as security.
II. Bonds payable – Contract between the issuer and lender specifying the terms of
repayment and interest to be charged.
Owner’s equity
I. Capital – Used to record original and additional investments of the owner of the
business entity. It is also increased by the amount of profit earned and decreased by
the amount loss incurred for the year.
II. Withdrawals – Temporary account used to record withdrawal or drawings of the
business owners.
III. Income summary – Temporary account used at the end of accounting period to
summarize and close income and expenses.
Income
I. Service income – revenues earned by performing services for a customer or client.
II. Sales – Revenues earned as a result of sale of merchandise.
Expenses
I. Cost of sales - cost incurred to purchase or to produce the products sold to customers during the
period.
II. Cost of services – cost incurred for performing services to customers or clients.
III. Salaries or wages expense – expenses for services performed by employees to the company.
IV. Utilities expense – expenses related to use of communication, electricity, water, etc.
V. Supplies expense – expense of using supplies for administrative services.
VI. Rent expense – expense for using leased spaces, equipment or other assets.
VII. Insurance expense – expired portion of premiums paid for insurance coverage.
VIII. Depreciation expense – portion of the cost of a tangible asset allocated or charged as expense
during the period.
IX. Doubtful accounts expense – amount of receivables estimated to be doubtful of collection and
charged as expense during the period.
X. Interest expense – an expense related to use of borrowed funds.
Accounting event and transactions
An accounting event is an occurrence that causes changes in an enterprise’s assets,
liabilities and/or equity.

An accounting transaction is a particular kind of event that involves the transfer of

something of value between entities.
Accounting equation
The most basic tool of accounting is the accounting equation. This equation states that
assets must always equal liabilities and owner’s equity. The basic accounting model is:

Assets = Liabilities + Owner’s Equity

Recording of any accounting event and transaction must maintain this equality.
Financial transaction worksheet
The financial transactions may 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.
Illustration
Modesto Accounting Services is a firm that provides a wide range of bookkeeping and
accounting services. This sole proprietorship business is owned by Dr. Emerita Modesto, a
CPA. The office is managed by Francisco Roxas, MBA.

During October 2019, the first month of operations, various financial transactions took
place. These transactions are described and analyzed in the following slides.
Initial transactions
Initial investment
Oct. 1 Emerita Modesto obtained the funds to start the business by withdrawing P800,000
from her personal savings. He deposited the money in a new bank account that he opened
in the name of the firm, Modesto Accounting Services.
Initial transactions
Purchasing Equipment on Credit
Oct. 3 Roxas bought a computer, a copy machine, a fax machine, calculators and other
necessary equipment from M. Medina, Inc., at a cost of P100,000. M. Medina, Inc., agreed
to allow 60 days for the firm to pay the bill.
Initial transactions
Purchasing Supplies for Cash
Oct. 5 Roxas placed an order for toner, fax paper, bond paper, CDs, pens, folders and other
supplies that had a total cost of P20,000. The entity that sold the items, Cavite Supplies,
Inc., requires cash payments from businesses that are under six months old. Modesto
Account Services therefore included a check with its order.
Initial transactions
Paying a creditor
Oct. 9 Roxas decided to pay P40,000 to M. Medina, Inc. to reduce the firm’s debt to that
business.
Effects of revenue and expenses
Selling services on credit
Oct. 13 Modesto Accounting Services earned P70,000 of revenue from charge account
clients. These clients are allowed 30 days to pay.
Effects of revenue and expenses
Employee’s salaries
Oct. 18 Modesto Accounting Services hired an accounting staff on Oct. 1 to help in the
business. The firm paid P25,000 in salaries for this employee and Francisco Roxas.
Effects of revenue and expenses
Collecting receivables
Oct. 23 Modesto Accounting Services received P30,000 from clients who had previously
bought services on account. This cash was applied to their accounts.
Effects of revenue and expenses
Selling Services for Cash
Oct. 27 Modesto Accounting Services earned a total of P210,000 in revenue from clients
who paid cash for accounting and bookkeeping services.
Effects of revenue and expenses
Utilities expense
Oct. 30 Modesto Accounting Services received a P35,000 bill for the utilities that it had
used during the month. A check was issued to pay the bill immediately.
Effects of revenue and expenses
Rent expense
Oct. 31 Modesto Accounting Services issued a check as payment for office rent for October.
The lease contract Modesto signed specified a monthly rent of P45,000.
Effects of Owner’s Withdrawals
Owner’s Withdrawal
Oct. 31 Emerita Modesto withdrew P150,000 in cash from the business to pay for personal
expenses.
The account
The account is the basic summary device of accounting. A separate account is maintained
for each element that appears in the statement of financial position and the statement of
comprehensive income. Increases, decreases and balances are reflected in these accounts.

The simplest form of account is known as the T-account because of its similarity to the
letter T.

Account Title
Debit Credit
(Left side of the account) (Right side of the account)
Double-entry system
Accounting is based on a double-entry system which means that the dual effects of a
business transaction is recorded. Each transaction affect at least two accounts, therefore,
for every one or more accounts debited there must be one or more accounts credited.

The total debits for a transaction must always equal the total credits.
Normal balance of an account
The normal balance of an any account refers to the side of the account where increases are
recorded.
Assets (Normal balance debit) Liabilities (Normal balance credit)
Debit Credit Debit Credit
Increases Decreases Decreases Increases

Drawings (Normal balance debit) Owner’s equity (Normal balance credit)

Debit Credit Debit Credit
Increases Decreases Decreases Increases

Expenses (Normal balance debit) Income (Normal balance credit)

Debit Credit Debit Credit
Increases Decreases Decreases Increases