Chapter 5

BC3BUM1 Fundamentals of Accounting and Reporting
References: Valencia, Edwin G. and Roxas, Gregorio F., BASIC ACCOUNTING 4 th Edition
Ballada, Win and Ballada, Susan, PARTNERSHIP AND CORPORATION ACCOUNTING 17 th Edition)
1. Normal Balance of Accounts 7. Flows of Accounting Activities

2. Rules of Debit and Credit 8. Analyzing and Accounting for Business
Transactions
3. Basic Accounting Equation 9. Business Activities
4. Work Capital 10. Preparation of Financial Statements
5. Business Transactions and 11. Relationships of Financila Statements
Accounting Equation
6. Owner’s Drawing Accounts vs.
Owners’s Capital Accounts
The accounting equation is divided into two sides (left and right) which are
accounted to always maintain a balanced amount.
In other words, if the SFP is considered immediately after each transaction, it
should always be that the total assets must be equal to the totals of the aggregate
liabilities and owner’s equity.
Assets = Liabilities and Capital
means the value received. means the value parted with.

Assets are initially recorded on the Liabilities and capital are initially recorded
debit side of the equation. To debit on the credit side. To credit a liability
an asset is to increase an asset. To and/or capital is to increase them. To debt
credit an asset is to decrease it. liability and/or capital means to decrease
them.
Expenses = Revenue
are initially recorded on are initially recorded on the

the debit side. To debit an expense credit side. To credit revenue means to
means to increase an expense. To increase an income. To debit revenue
credit an expense is to decrease it. means to decrease it.
The of the accounting equation is an application of the

which provides that every value received must have a corresponding value
parted with. This concept is the basis of the debit and credit in recording economic
transactions and events.
The two equal sides define the foundation of the rues of debit and credit.
The rules of debit and credit are based on the normal balance of an accounting
element or account. The term refers to the usual
position of an account in the .
Asset accounts are normally in the debit side while the liability and owner’s
capital accounts are normally in the credit side.
The normal balance of an account provides the basis in analyzing when to debit
and credit an account. The following rules must be observed when to debit or credit an
asset, liability and capital accounts.
Debit to increase the amounts of asset.

Credit to decrease its amount.
Debit Credit
Increases Decreases
To illustrate, assume the following information:

1. January 5, Pearl Service b rlGrBT1 002 ref*289.1 prlG bo teh6( )-4(b)6(f)-4( )-4(au)6(mp)10(p)6(
Using the effects of revenue and expense to the capital account, the rules of
debit and credit for the statement of comprehensive income elements can be stated as
follows:
Credit to increase the revenue amount.
Debit to decrease its amount.
Debit Credit
Decreases Increases

1. December 1 - Pearl Service recorded service income of P10,000 cash.
2. December 31 – Pearl determined that the recorded service income on December
31 should not be P10,000. The correct amount is P1,000. Pearl reduced the
service income by P9,000.
Observe that the remaining balance of service income account after decreasing it by
P9,000 is the correct amount of P1,000.
Using the T-account method, the analysis would be as follow:
Decreas Debit Credit Increase

e 12/31 9,000 12/1 10,000
1,000
Remaining
correct
balance of
revenue.
Debit to increase expenses account.

Credit to decrease its amount.
Debit Credit
Increases Decreases

1. December 15 - Pearl Service paid P12,000 for the rent expense.
2. December 31 – Pearl Service discovered that the correct amount of rent expense
is P1,200 instead of P12,000. Pearl reduced the rent expense account by
P10,800.
Observe that after the credit to the rent expense by P10,800 its balance was
reduced to P1,200. Using the T-account method, the analysis would be as follows:
Increase Debit Credit Decrease

12/31 12,000 12/15 10,800
1,200
Remaining
correct
balance of
expense.
The T-account, when used as a tool to analyze the effects of business

transactions, maintains the equation: .
Reflecting the rules of debit and credit in the t-accounts could be summarized as
follows:
Increase in: Decrease in:

 Assets  Assets
 Expenses  Expenses
 Losses  Losses
Decrease in: Increase in:

 Liabilities  Liabilities
 Capital  Capital
 Revenue  Revenue
 Profit  Profit
The recording of business transactions is based on the basic accounting

equation. This accounting equation is derived from the dual concept of accounting
which states that in every debit (value received) there must be a corresponding credit
(value parted with) or vice versa.
The accounting equation is an accounting formula expressing the equality of
asset and equity (liabilities and capital) in every business transaction.
This equation is made up of the elements comprising the Statement of Financial
Position as expressed in the following formula:
represent economic resource are the

or things of value owned by the equities of creditors and owner(s) in
business. These are divided from the business. They represent the
loans, contributions of the owner(s), claims of the creditors and owner(s)
and income from business operations. over the assets of the enterprise.
This accounting equation plays a vital role in analyzing and recording economic
transactions and events of a business enterprise.
The formula implies that a business, being a separate economic entity from its
owner, generally acquires economic resources (assets) which are contributed by its
creditor(s) (liabilities) and owner(s).
The position of liabilities in the equation being near to the assets implies that the
third-party creditors shall obtain first priority over the assets of the enterprise.
Accordingly, this idea results to a modified accounting equation expressed as
follows:
Net Assets to the Owners
This modified basic accounting equation implies that the owner’s equity would
only be the residual value of assets after the creditors have secured their claims over
the assets of the enterprise. Thus,
If the business has assets in the amount of P100,000
and a liability of 30,000
the owner’s equity (capital) is P
Another modified accounting equation could be expressed as follows:
Net Assets to the Creditors

This accounting formula means that the creditor’s claim over the assets of the
enterprise is determined when the owner’s interest is deducted from the total assets of
the enterprise. Thus,
If the business has assets in the amount of P100,000
and the owner’s equity (capital) of 70,000
the creditors’ claims would be P
So, the assets of the enterprise are claims of the owner(s) or creditor(s), or both.
The basic accounting equation depicts only the statement of Financial Position
elements. It is because they represent real (permanent) accounts which are usually
maintained at the end of the accounting period.
The revenue (profit/income) and expense (loss) accounts, as elements of the
statement of comprehensive income are only nominal (temporary) accounts. They are
usually closed to the capital account at the end of the accounting period.
The capital account is increased by any revenue (profit or income) and
decreased by any expense (loss). Accordingly, the accounting equation can be
expressed in its expanded form as follows:
Permanent Initial Investment

Withdrawals Additional
Temporary Investment
Withdrawals Income/revenue
Losses/expenses
From the accounting equation, the equation for working capital has been derived.
The term refers to the difference of business current assets and

current liabilities, which ensures that the business has sufficient resources to continue
its operations smoothly and avoid costly interpretations. Lack of working capital can
lead to a failure of a business. Thus,
If the business has current assets in the amount of P 70,000

and current liabilities of 35,000
the business working capital would be P
In this case the working capital ratio is 2:1, computed as follows:
Current assets P 70,000

divide by current liabilities P 35,000
working capital ratio
The ratio implies that in every P1 current liability, the business has an available
P2 to pay. Thus, the excess of P1 can be used as current back-up resources to
continue the current operations smoothly.
Generally, the working capital involves a number of activities related to the firm’s
cash receipts and cash disbursements as follows:
Cash may be derived from: Cash may be derived from:

1. Revenue from current operations 1. Payments of business expenses
2. Sale of noncurrent assets 2. Purchase of noncurrent assets
3. Long-term borrowings 3. Payment of long-term liabilities
4. Additional investment(s) of owner 4. Personal drawings of the owner
To illustrate, the working capital related to cash activities of A-1 Barbershop is

presented as follows (All amounts are assumed):
Sources of cash:
Gross receipts as service fee P 100,000
Additional investment of X 50,000
Proceeds of loan from the bank 50,000 P 200,000
Less: Uses of cash
Purchase of Barbershop equipment P 120,000
Payment of Barbers’ commission 60,000 P 180,000
Balance P 20,000
Add: Cash beginning 5,000
Cash available, ending P 25,000
The cash and disbursements is a simplified cash flow statement.
Every business transaction affects two or more accounts. The transactions are
recorded in the accounting books using the double-entry system. In each transaction,
the value of debits is always equal to the value of credits.
Debit Credits
1. The owner invested Increase in cash (asset) 100,000
P 100,000
Cash in his business Increase in Owner’s 100,000
Equity
In accounting equation form, the effect is described as:

Asset = Liabilities + Owner’s equity
P100,000 = P–0- + P100,000
Debit Credits
2. Purchased equipment Increase in Equipment 20,000
(asset)
P20,000 Decrease in Cash 5,000
P5,000 down payment Increase in Accounts Payable 15,000
Balance on account (liability)
In accounting equation form, the effect is described as:

(P5,000)
20,000 = P 15,000 + P–0-
Debit Credits
3. Recovered P50,000 Increase in cash (asset) 50,000
Proceeds of loan granted Increase in notes 50,000
Payable
by the bank. Issued (liability)
P50,000 promissory
note for the amount.
To summarize the effect of the accounting transactions numbers 1, 2, and 3 in

the accounting equation form, it will appear as follows:

Cash Accts payable
P145,000 P15,000
Equipment Not Payable Owner’s equity
20,000 50,000 P100,000
Total = +
P165,000 P65,000 P100,000
the total amount of assets equals the total amount of liabilities and owner’s
equity.
The following comparative T-accounts summarize the rules when to use the
owner’s drawing account and the owner’s capital account.
1. Temporary withdrawals 1. Periodic owner’s salaries

2. Owner’s personal debts paid for 2. Business debts assumed or paid by
assumed by the business the owner
3. Funds or claims of the business 3. Personal funds or claims of owner
collected and retained by the owner. collected and retained by the
business
4. Share in the business losses 4. Share in business profits.
1. Permanent withdrawals of capital 1. Original investment

2. Closing of the net debit balance of the 2. Additional investment
drawing account
3. Closing of the net debit balance of the 3. Closing of the net credit balance of
income summary account the income summary account.
The process of analyzing accounting transactions comprises the determination of

accounting elements affected and their effects in the accounting equation, the choice of
the appropriate account title to be debited or credited and the computation of the correct
amount to be recorded in the books of accounts.
Usually, accountant mentally answer the following questions:
Question No. 1 – What is the value received? (Debit)
Question No. 2 – What is the value parted with? (Credit)
Question No. 3 – What accounting elements are affected?

(Assets, Liabilities, or Owner’s Equity)
Question No. 4 – What are their effects to the affected accounting elements?
(Increase or decrease in Assets, Liabilities or Owner’s Equity)
Question No. 5 – What appropriate account title will describe the effect of transactions?
Question No. 6 – How much is the amount to be recorded for a particular account title?
An analysis of the effect of a transaction should always be guided by the basic

rules of debit and credit as follows:
Increase in: Decrease in:

 Assets  Assets
 Expenses  Expenses
Decrease in: Increase in

 Liabilities  Liabilities
 Owner’s equity  Owner’s equity
 Revenues  Revenues
To illustrate, assume that Big Store bought on account a computer to be used as

store equipment for P25,000.
The mental analysis that may be made by an accountant would be:
Value received Computer

Value parted with Obligation to pay
Accounting elements affected Asset Liability
Effects to accounting elements Increase Increase
Account titles Store equipment Account payable
Amount P25,000 P25,000
To illustrate the analyzing process of accounting, consider the December 200x

transactions of VALROX, a servicing business.
Cash received per (P500,000)

The business entity’s issuance of official receipts to the owner of the
business is an application of the accounting concepts of separate entity and objectivity.
Cash
Accounting element affected: Asset
Account to be debited: Cash on hand
Amount to be debited: P500,000
Claim of the owner in the business

Accounting element affected: Owner’s equity
Account to be credited: Val Rox, Capital
Amount to be credited: P500,000
The analysis of the economic transaction is based on dual entry bookkeeping

which observe the rule that for every transaction, value received (debit) is always equal
to value parted with (credit).
After the economic transaction is analyzed, it is followed by the recording in the
books of accounts.
Cash deposited per (P500,000)
Cash
Account to be debited: Cash in bank
Cash
Account to be credited: Cash on hand
Hired Miss Tica Mona as secretary of the business who agreed to be

paid for a daily minimum wage of P280.
This transaction has no financial effect to the business. It does not yet affect any
accounting element because Miss Mona was just hired and no actual services (value)
were received yet from her. Consequently, there is no corresponding value parted with
for this transaction.
Therefore, there is no amount to be recorded in the books of accounts.
Cash payment per (P5,000)
Supplies
Accounting element affected: Expenses
Account to be debited: Supplies expenses
Cash
Account to be credited: Cash in bank
Cash payment for electricity per
Electricity consumed
Accounting element affected: Expense
Account to be debited: Utility expense
Cash
Acquisition of office computer per (50,000)
Computer
Account to be debited: Office equipment
Cash and obligation to pay

Accounting element affected: Asset and Liability
Account to be credited: Cash in bank and notes payable
Amount to be credited: P5,000 and P45,000, respectively.
Cash receipts per (P150,000)
Cash
Account to be debited: Cash on hand
Services rendered
Accounting element affected: Revenue
Account to be credited: Service income
Cash deposited per (P150,000)
Cash
Cash
Issued check on December 16 to pay the payroll for the period per
attached (P8,508)
Employee’s service
Accounting element affected: Expenses
Cash in bank, liability to SSS and BIR

Accounting element affected: Asset and Liabilities
Account to be credited: Cash in bank, SSS payable
Amount to be credited: P6,508, P1,550 and P450 respectively
Billed to the customer for services rendered as per attached

(P50,000)
Collectible from U Tongue Enterprises

Account to be debited: Account receivable
Service rendered
Accounting element affected: Revenue
Account to be credited: Service income
Received a from the bank (P100)
Bank service
Accounting element affected: Expense
Account to be debited: Bank charges expense
Amount to be debited: P100
Cash
Amount to be credited: P100
Check payment of notes payable (P45,000)
Cancellation of obligation to pay

Accounting element affected: Liability
Account to be debited: Notes payable
Cash
Personal drawings of Val Rox. (P500)
Cancellation of owner’s claim

Accounting element affected: Owner’s equity
Account to be debited: Val Rox, Drawing
Amount to be debited: P500
Cash
Amount to be credited: P500
The economics of the business are classified into

and
The are those transactions which are conducted to
generate revenue for the business. These include ordinary and necessary expenses
incurred to effect sales and/or to perform services as sources of revenue.
The items on operating activities and their effects on cash flows are:
Cash receipts from: Cash payments for:

 Sale of goods or service Purchase of inventory
 Sale of trading securities Operating expenses
 Interest income Taxes
 Dividend income Interest expense (short-term)
Purchase of trading securities
The arise from business transactions involving acquisition

and disposal of assets other than inventory, which are needed in the operation of the
business.
The primary purpose of investigating activities is to acquire an asset in order to
assist and facilitate business operations.
Below are the items on investing activities and their effects on cash flows:

 Sale of plant assets Purchase of plant assets
 Sale of non-trading securities Purchase of non-trading securities
 Sale of business segment Making loans to other entities
 Collection of loans
The refer to transactions between the business and its

owner(s) and Creditors (lenders).
The main concern of the business’s financing activity is to raise working capital to
be used for business operations. The owner(s) and also creditor(s) could provide the
needed capital as loan to the business.
Below are the items on financing activities and their effects on cash flows:

 Owner’s investments Owner’s drawings
 Borrowings Payment of borrowings

Chapter 5

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 5

Uploaded by

Copyright:

Available Formats

BC3BUM1 Fundamentals of Accounting and Reporting

1. Normal Balance of Accounts 7. Flows of Accounting Activities

Assets = Liabilities and Capital

means the value received. means the value parted with.

are initially recorded on are initially recorded on the

The of the accounting equation is an application of the

Debit to increase the amounts of asset.

To illustrate, assume the following information:

To illustrate, assume the following information:

Decreas Debit Credit Increase

Debit to increase expenses account.

To illustrate, assume the following information:

Increase Debit Credit Decrease

The T-account, when used as a tool to analyze the effects of business

Increase in: Decrease in:

Decrease in: Increase in:

The recording of business transactions is based on the basic accounting

represent economic resource are the

Net Assets to the Owners

Net Assets to the Creditors

Permanent Initial Investment

The term refers to the difference of business current assets and

If the business has current assets in the amount of P 70,000

In this case the working capital ratio is 2:1, computed as follows:

Current assets P 70,000

Cash may be derived from: Cash may be derived from:

To illustrate, the working capital related to cash activities of A-1 Barbershop is

In accounting equation form, the effect is described as:

In accounting equation form, the effect is described as:

To summarize the effect of the accounting transactions numbers 1, 2, and 3 in

Asset = Liabilities + Owner’s equity

1. Temporary withdrawals 1. Periodic owner’s salaries

1. Permanent withdrawals of capital 1. Original investment

The process of analyzing accounting transactions comprises the determination of

Question No. 3 – What accounting elements are affected?

An analysis of the effect of a transaction should always be guided by the basic

Increase in: Decrease in:

Decrease in: Increase in

To illustrate, assume that Big Store bought on account a computer to be used as

Value received Computer

To illustrate the analyzing process of accounting, consider the December 200x

Cash received per (P500,000)

Claim of the owner in the business

The analysis of the economic transaction is based on dual entry bookkeeping

Cash deposited per (P500,000)

Hired Miss Tica Mona as secretary of the business who agreed to be

Therefore, there is no amount to be recorded in the books of accounts.

Cash payment per (P5,000)

Cash payment for electricity per

Acquisition of office computer per (50,000)

Cash and obligation to pay

Cash receipts per (P150,000)

Cash deposited per (P150,000)

Cash in bank, liability to SSS and BIR

Billed to the customer for services rendered as per attached

Collectible from U Tongue Enterprises

Received a from the bank (P100)

Check payment of notes payable (P45,000)

Cancellation of obligation to pay

Personal drawings of Val Rox. (P500)

Cancellation of owner’s claim

The economics of the business are classified into

Cash receipts from: Cash payments for: