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Fundamentals of Accounting 1

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 TOPIC: The Accounting Equation

 ACCOUNTING EVENTS AND TRANSACTIONS

 ACCOUNTING INFORMATION SYSTEM
 TYPES OF ACCOUNTING INFORMATION SYSTEMS
 ELEMENTS OF FINANCIAL STATEMENTS
 THE ACCOUNT
 THE ACCOUNTING EQUATION
 DEBITS AND CREDITS – THE DOUBLE-ENTRY SYSTEM
 NORMAL BALANCE OF AN ACCOUNT
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 OBJECTIVES

a) Distinguish between accounting event and transaction.

b) Explain how an accounting information system helps the decision makers.
c) Define the elements of financial statements.
d) d) Describe the nature of the typical account titles used in recording
transactions.
e) Describe the account ( the simple T-account) and its uses.
f) Define debits and credits Silay Institute, Incorporated
 Introduction

The starting point in the accounting process is an analysis of the

transactions of a business. A business transaction is any financial event that
changes the resources of a firm. For example, purchases, sales, payments and
receipt of cash are all business transactions. The accountant must look at the
effects of each business transaction to decide what information to record and
where to record it. Thus, the study of accounting begins with an investigation
into how the accountant analyzes business transactions.
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 ACCOUNTING EVENTS AND
TRANSACTIONS

An accounting event is an economic occurrence that causes changes in

an enterprise’s assets, liabilities, and/or equity. Events may be internal actions,
such as the use of equipment for the production of goods or services. It can also
be an external event, such as the purchase of raw materials from a supplier.
A transaction is a particular kind of event that involves the transfer of
something of value between two entities. Examples of transactions include
acquiring assets from owner(s), borrowing funds from creditors, and purchasing
or selling goods and services.

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 ACCOUNTING INFORMATION SYSTEM

Every business organization must have an accounting information system

which will generate reliable financial information needed by the decision-makers in a
timely manner. The design and operation of a system must consider the anticipated
users of the information and the types of decisions they are expected to make. The
design of the system to meet the entity’s information requirement depends on the
firm’s size, nature of operations, volume of transaction data, organizational structure,
form of business and extent of government regulation. These will influence the way
in which information is accumulated and reported in the financial statements.
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 An accounting information system is the combination of personnel,
records and procedures that a business uses to meet its need for financial
information. Most firms have an accounting manual that specifies the policies
and procedures to be followed in accumulating information within the
accounting information system. This manual details what events are to be
recorded in the accounts, and when and how the information is to be classified
and accumulated.
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 An effective accounting information system
should achieve the following objectives:

▰ To process the information efficiently at the least cost

(cost-benefit principle)
▰ To protect entity’s assets, to ensure that data are reliable, and to minimize
wastes and the possibility of theft or fraud (control principle)
▰ To be in harmony with the entity’s organizational and human factors
(compatibility principle).
▰ To be able to accommodate growth in the volume of transactions and for
organizational changes ( flexibility principle)

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 The
The diagram illustrates how economic Accounting
Process
activities flow into the accounting process,
which produces accounting information.
Economic Accounting
This information is then used by decision Activities Information
makers in making economic decisions and taking
specific actions, thus, resulting in economic activities.
The cycle goes on. Decision

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 TYPES OF ACCOUNTING INFORMATION
SYSTEMS
In general terms, companies use three types of accounting information systems
to record the results of transactions:
1. Manual systems
2. Computer – based transaction systems
3. Database systems
All of these systems are designed to capture information regarding accounting
events to prepare financial statements.
In a nutshell, manual systems utilize paper-based journals (general and special)
and ledgers (general and subsidiary. Computer –based transaction systems replace paper
records with computer records. Database systems embed accounting data within the
business event data on which they are based.
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 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.
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 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.
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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, owner’s equity, or shareholders’ or stockholders’ equity,
consists of share capital or capital stock, retained earnings and reserves
representing appropriations of retained earnings among others.
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 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). 15
 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.

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 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.
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 Losses represent other items that meet the definition of
expense and may or 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.

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 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 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”.
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T - Account

Account Title
________________________________

Left side or Right side or

Debit side Credit side

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 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 equal liabilities and owner’s equity.
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The basic accounting model is:

A L OE
Assets = Liabilities + Owner’s Equity

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▰ 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.
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 DEBITS AND CREDITS – THE DOUBLE-
ENTRY SYSTEM

Accounting is based on a double-entry system which means that

the dual effect 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 debited.
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 abbreviation for debit and credit are Dr. (from the Latin debere) and
Cr. (from the Latin credere), respectively.
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 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.
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The following summarizes the rules:

Balance Sheet Accounts

_________________________________________________________________
Assets Liabilities and Owner’s Equity
__________________ _____________________________

Debit Credit Debit Credit

(+) (-) (-) (+)
Increases Decreases Decreases Increases

Normal Balance Normal Balances

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 Income Statement Accounts
_________________________________________________
Debit for Credit for

decreases in owner’s equity increases in owner’s equity

Expenses Income
_____________________ ____________________
Debit Credit Debit Credit
(+) (- ) (-) (+)
Increases Decreases Decreases Increases

Normal Balance Normal Balances

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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.

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 Normal Balances of Accounts

Increases Recorded by Normal Balance

Account Category Debit Credit Debit Credit
Assets ✔ ✔

Liabilities ✔ ✔

Owner’s Equity:

Owner’s Capital ✔ ✔

Withdrawal ✔ ✔

Income ✔ ✔

Expenses ✔ ✔

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THANK YOU!

Silay Institute, Incorporated