UNIT II

Accounting Concepts and Principles

Topics: Business Transactions
Sources of Documents
Fundamentals of Accounting
Accounting Equation
Elements of Accounting Equation

BUSINESS TRANSACTIONS

A business transaction (accountable events) is any event that affect the financial position
of the business and can be recorded reliably. It involves exchange of values. There are
transactions within the organization like recognizing the used portion of supplies as expense,
or with outside entities or persons like purchasing supplies either for cash or on account /on
credit.

Below are examples of transactions for a newly organized Accounting Firm.

1. The owner invested cash for the firm.

2. Purchase of office supplies on account.
3. Purchase of office supplies for cash.
4. Payment of accounts payable.
5. Provide services for cash.

SOURCES OF DOCUMENTS

These are the evidences of the daily activities of a business enterprise. It helps us to identify
the transactions that should be recorded in the books of accounts. The common examples of
source of documents of a service type of business are:

1. Official Receipt - are documents that are

issued to customers as a proof of sales. It is
issued normally upon receipt of payment from
the buyer.
 2. Check and check Stubs. This the source
document for all payments made. The check stub
must be properly filled to include all information
needed in recording the payment.

3. Deposit Slips. These are the evidences that

the cash received as indicated in the official
receipts issued are deposited in the bank. This
slip indicates the name of the enterprise or the
name of the owner of the business enterprise,
the account number and the amount deposited.

4. Statement of Account. This is a formal notice

showing the details of the amount billed to
client, or detail of account already due.

5. Payroll. This serves as the basis of

recording the salaries paid to employees.

Importance of Source Documents

The source document is essential to the bookkeeping and accounting process as it

provides evidence that a financial transaction has occurred. During an accounting or tax audit,
source documents back up the accounting journals and general ledger as an indisputable
transaction trail.

You would keep source documents for your business just like you keep receipts for tax-
deductible items for your taxes. If your taxes are audited, the source documents provide the
proof that you've made those purchases. The same holds for your business, but in business,
you keep original documents for every financial transaction, not just charitable donations.

FUNDAMENTALS OF BASIC ACCOUNTING

What is an Account?

In accounting, an account is a descriptive storage unit used to collect and store

information of similar nature.

For example, "Cash".

Cash is an account that stores all transactions that involve cash receipts and cash
payments. All cash receipts are recorded as increases in "Cash" and all payments are recorded
as deductions in the same account.

Another example, "Building". Suppose a company acquires a building and pays in cash.
That transaction would be recorded in the "Building" account for the acquisition of the building
and a reduction in the "Cash" account for the payment made.

ACCOUNTING EQUATION

All the processes in accounting system must observe the equality of the accounting equation,
which is basically an algebraic equation.

Assets = Liabilities + Owner’s Equity

ASSETS

Assets refer to resources owned and controlled by the entity as a result of past
transactions and events, from which future economic benefits are expected to flow to the entity.
In simple terms, assets are properties or rights owned by the business. They may be classified
as current or non-current.

A. Current assets – Assets are considered current if they are held

for the purpose of being traded, expected to be realized or
consumed within twelve months after the end of the period or its
normal operating cycle (whichever is longer), or if it is cash.
Examples of current asset accounts are:
 Cash– includes money and any medium of exchange acceptable by bank for deposit
such as bills, coins, funds for current purposes, checks, cash in bank, etc.

Accounts Receivables – due from customers for services rendered on account

(receivable from customers)

Notes Receivable- due from customer evidenced by a written promise to pay a

definite sum of money for a specified period of time (receivables supported by
promissory notes)

Prepaid expenses – expenses paid in advance, such as, Prepaid Rent, and Prepaid
Insurance

Supplies- Includes all types of supplies or more specifically as Office supplies

B. Non-current assets – Assets that do not meet the criteria to be

classified as current. Hence, they are long-term in nature – useful for a
period longer that 12 months or the company's normal operating cycle.
Examples of non-current asset accounts include:

Long-term investments – investments for long-term

purposes such as investment in stocks, bonds, and
properties; and funds set up for long-term purposes

Land – land area owned for business operations (not for sale)

Building – such as office building, factory, warehouse, or store

Equipment – Machinery, Office Equipment, Computer Equipment, Delivery Equipment,

and others

Furniture and Fixtures - shelves, tables, chairs, filing cabinets, paintings

Liabilities

Liabilities are economic obligations, debts or payables of the

business.

A. Current liabilities – A liability is considered current if it is

due within 12 months after the end of the balance sheet date.
In other words, they are expected to be paid in the next year.

If the company's normal operating cycle is longer than 12

months, a liability is considered current if it is due within the operating cycle.
 Current liabilities include:

Accounts payable- for the cost of purchases on credit

Notes payable- for liabilities evidenced by written promised to pay a specific

amount of money in the future

Interest payable- interest incurred but not yet paid. Interest payable arises form
interest- bearing liabilities

Salaries payable- salaries already earned by employees but not paid by the
business

Utilities payable- e.g. electricity bills, water bills, telephone bills, internet, cable tv,
etc. already used but not yet paid

Loans payable - A loan payable differs from accounts payable in that accounts payable
do not charge interest (unless payment is late) and are typically based on goods or
services acquired. A loan payable charges interest and is usually based on the earlier
receipt of a certain sum of cash from a lender.

Current tax liabilities – taxes for the period and are currently payable

B. Non-current liabilities – Liabilities are considered non-current if they are not currently
payable, i.e. they are not due within the next 12 months after the end of the accounting period
or the company's normal operating cycle, whichever is shorter.

In other words, non-current liabilities are those that do not meet the criteria to be considered
current. Hah! Make sense? Non-current liabilities include: Long-term notes, bonds, and
mortgage payables; Deferred tax liabilities; and Other long-term obligations

Owner’s Equity/Stakeholder’s Equity (Capital)

Capital refers to what is left to the owners after all liabilities are settled.

Simply stated, capital is equal to total assets minus total liabilities.

Capital is affected by the following:

Initial and additional contributions of owner/s (investments),

Withdrawals made by owner/s (dividends for corporations)

Owner contributions and income increase capital while withdrawals and expenses decrease it.
Income increases the capital while expenses decrease the capital

Income Statement Accounts

Income

Income refers to an increase in economic benefit during the accounting period in the form of
an increase in asset or a decrease in liability that results in increase in equity, other than
contribution from owners.

Revenues refer to the amounts earned from the company’s ordinary

course of business such as professional fees or service revenue for
service companies and sales for merchandising and manufacturing
concerns.

Gains come from other activities, such as gain on sale of equipment, gain
on sale of short-term investments, and other gains.

Expense

Expenses are decreases in economic benefit during the

accounting period in the form of a decrease in asset or an
increase in liability that result in decrease in equity, other
than distribution to owners.

Net income refers to all income minus all expenses.

List of Expense Accounts

Advertising Expense - costs of promoting the business such as those incurred in

newspaper publications, television and radio broadcasts, billboards, flyers, etc.

Bank Service Charge - costs charged by banks for the use of their services

Delivery Expense - represents cost of gas, oil, courier fees, and other costs incurred
by the business in transporting the goods sold to the customers. Delivery expense is
also known as Freight-out.

Insurance Expense - insurance premiums paid or payable to an insurance company

who accepts to guarantee the business against losses from a specified event

Interest Expense - cost of borrowing money

Rent Expense - cost paid or to be paid to a lessor for the right to use a commercial
property such as an office space, a storeroom, a building, etc.

Repairs and Maintenance - cost of repairing and servicing certain assets such as
building facilities, machinery, and equipment

Representation Expense - entertainment costs for customers, employees and

owners. It is often coupled with traveling, hence the account title Travel and
Representation Expense.

Salaries Expense - compensation to employees for their services to thcompany

Supplies Expense - cost of supplies (ball pens, ink, paper, spare parts, etc.) used by
the business. Specific accounts may be in place such as Office Supplies Expense,
Store Supplies Expense, and Service Supplies Expense.

License Fees and Taxes - business taxes, registration, and licensing fees paid to the
Government

Telecommunications Expense - cost of using communication and telephony

technologies such as mobile phones, land lines, and internet

Training and Development - costs for the enhancement of employee skills

Utilities Expense - water and electricity costs paid or payable to utility companies

Words to Remember

 Assets - refer to resources owned and controlled by the entity as a result of past transactions and events, from which future
economic benefits are expected to flow to the entity
 Capital - refers to what is left to the owners after all liabilities are settled
 Expense- is the cost of operations that a company incurs to generate revenue
 Income- is money (or some equivalent value) that an individual or business receives in exchange for providing a good or
service or through investing capital
 Liabilities are economic obligations, debts or payables of the business
 Stocks - (also capital stock) of a corporation is all of the shares into which ownership of the corporation is divided.
Topics: Analysis of Business Transaction
Accounting Equation
Expanded Accounting Equation

The two sides of the accounting equation are always equal. The left side of the equation show
how much the business owns; and the right side of the equation show how much resources
do the outside creditor and owner supplied to the business.

Illustration 1:

You decided to put up a barbeque stand and have estimated that you will be needing
P2,000 as the start-up capital.

You then went to your closet and broke your piggy bank which you have been saving for
quite some time now. Then you found that you only have P800. You went to your mom
and ask her to give you P1,200 but she told you that she has been feeding you for far too
long. Oh man! But don’t give up yet, Mr. Bombay is just around the corner.

Assets = Liabilities + Owner’s Equity

800 = 0 + 800

 Your total assets are P800-the amount of resources that you control
 You don’t have any liability yet because you are still negotiating with Mr. Bombay.
 Your equity is also P800 (800 assets – 0 liability= 800 equity)

After the negotiation, Mr. Bombay agreed to lend you P1,200. The equation will be:

Assets = Liabilities + Owner’s Equity

2,000 = 1,200 + 800

 Your total assets are now 2,000- the total amount of resources that you control ( P800
from piggy bank plus P1,200 from Mr. Bombay.
 Of your total assets of P2,000:
a. P1,200 represents your liability, the amount you are obligated to pay Mr.
Bombay in the future
b. P800 represent your equity (P2,000 assets – P1,200 liabilities)
 Your equity is also P800 (800 assets – 0 liability= 800 equity)
 Notice that from piggy bank to Mr. Bombay, the accounting equation remains balanced. DO
NOT FORGET THIS CONCEPT! The equality of the accounting equation must be maintained
in all the accounting processes of recording, classifying, and summarizing. If the accounting
equation is not balanced, there is something wrong.

As mentioned earlier, the accounting equation is basically an algebraic equation.

Therefore, we can make variations from it. Analyze the following variations below:

Original form of the equation:

Assets = Liabilities + Equity
2,000 = 1,200 + 800

Variation #1
Assets - Liabilities = Equity
2,000 - 1,200 = 800
Look at the operations (Assets -Liabilities =Equity)

Variation #2
Assets - Equity = Liabilities
2,000 - 800 = 1,200
(Assets -Equity =Liabilities)

Let us now analyze different transactions based on the concept mentioned above to prove the
equality of the accounting equation:

The business is a newly organized accounting firm by G.A Rante

TRANSACTION 1: The owner invested P100, 000 to start an accounting office on May 1,
2019.
Assets = Liabilities + Owner’s Equity

Cash G.A. Rante Capital

100,000 = 0 + 100,000

The effect of the transaction is increase in asset (cash) and increase in owner’s equity (capital).
TRANSACTION 2: Purchased office supplies worth of P20,000 on account.

Assets = Liabilities + Owner’s Equity

Office Supplies Accounts payable

20,00 = 20,000 + 0
The effect of transaction 2 is increase in asset (office supplies) and increase in liabilities
(accounts payable). Take note that the equality of the two sides of the equation is maintained.

***Note: If the purchasing transaction is made on account it is under liability (accounts payable)

TRANSACTION 3: Purchased additional office supplies for cash, P10,000

Assets = Liabilities + Owner’s Equity

Cash Office Supplies

-10,000 +10,000 = 0 + 0

The effect of transaction 3 is increase in asset (office supplies) and decrease in another form
of asset (cash).

TRANSACTION 4: Paid the accounts payable made on transaction 2 in full.

Assets = Liabilities + Owner’s Equity

Cash Accounts payable

-20,000 = -20,000 + 0

Transaction 4 decreases both sides of the equation which is Assets (cash) and Liabilities
(Accounts Payable) by P20, 000

TRANSACTION 5: Purchased 2 units of computer with printer for P60,000 on account

Assets = Liabilities + Owner’s Equity

Office Equipment Accounts payable

60, 000 = 60,000 + 0

The effect of transaction 5 is increase in asset (office Equipment) and increase in liabilities
(accounts payable).

The Expanded Accounting Equation

We can expand the basic accounting equation by including two more elements –income
and expenses. The expanded accounting equation shows all the financial statement elements.
The expanded accounting equation is as follows:

Assets = Liabilities + Owner’s Equity + Income - Expenses

Notice that income is added while expenses are deducted in the equation. These are
because income increases equity while expenses decrease equity.
The difference between income and expense represent PROFIT or LOSS.
 If income is greater than expense, the difference is PROFIT.
 If income is less than expense, the difference is LOSS.
 The expanded accounting equation with profit or loss is as follows:

Assets = Liabilities + Owner’s Equity + Profit/-Loss

Illustration 2:
During the period, you earned income of P10, 000 an incurred expense of P6, 200.
At the end of the period. Your total assets increased from P2, 000 to P5, 000 and your
total liabilities decreased from P1, 200 to P400.
Your expanded accounting equation is as follows:

Assets = Liabilities + Owner’s Equity + Income - Expenses

5, 000 = 400 + 800 + 10, 000 - 6, 200

We can also derive the following variation from the equation above:

+ Expenses = Liabilities + Owner’s Equity + Income

Assets
+ 6, 200 = 400 + 800
+ 10, 000
5, 000

Your profit for the period is P3, 800 (P10, 000 income minus P6, 200 expense). There is a profit
because income is greater than expenses.
A variation of the expanded accounting equation is shown below:

Assets = Liabilities + Owner’s Equity + Profit/-Loss

5, 0000 = 400 + 800 + 3, 800

Income and expenses (Profit or Loss) are closed to equity at the end of each accounting period.
Thus, the adjusted ending balance of equity is computed as follows:
Equity, beginning 800
Add: Income 10, 000
Less: Expenses (6, 200)
Equity, ending 4, 600

Or

Equity, beginning 800

Add: Profit 3, 800
Equity, ending 4, 600
Your basic accounting equation as of the end of the accounting period is as follows:

Assets = Liabilities + Owner’s Equity

5, 000 = 400 + 4, 600

Notice that regardless of its form or variation, the accounting equation (basic or expanded)
remains balanced.