HANDOUT IN FUNDAMENTALS OF ACCOUNTING, BUSINESS AND MANAGEMENT (FABM) 1

CHAPTER 2: THE ACCOUNTING EQUATION AND ACCOUNTING PROCESS

LEARNING OBJECTIVES
At the end of this chapter, you are expected to:

1. give and explain the accounting equation;

2. identify the elements of financial statements and how they are presented;
3. Identify the steps in the accounting process;
4. Identify, analyze, and measure business transactions;
5. Record business transactions applying the rules of debit and credit; and
6. name the different books of accounts and identify their uses.

LESSON 1: THE ACCOUNTING EQUATION

The basic accounting equation is expressed as:

ASSETS = LIABILITIES + CAPITAL

The equation has two sides. The left side of the equation is for the ASSETS which represents
what the business owns. The right side is for LIABILITIES and CAPITAL. Liabilities represent the claims
of the business’ creditors while capital represents the residual interest of the owners of the business.
Remember that just like in any equation, the two sides of the equation should always be balanced.

In using the accounting equation, one must remember the accounting identity which means
that the equality must be maintained throughout all transactions. As such, to maintain this identity,
transactions always have a dual effect on the accounting equation. Each transaction of the
company would have to affect two or more accounts in order for the equation to remain balance.
Such accounts may be on the same side, that is, (increase in Asset and decrease in another Asset)
or on both sides of the equation, that is, (increase in Asset and increase in Equity) or (increase in
Asset and increase in Liability). Always remember that each element of the equation has different
elements involved: Asset – the kinds of Assets; Liability – the kinds of Liability; Equity – the owner’s
capital, revenue and the kinds of expense.
Examples of ASSET accounts (these are DEBIT accounts) are Cash, Accounts receivable,
Unused supplies, merchandise inventory, Land, Building, Office equipment, Furniture and Fixtures,
these are among the tangible assets because there are many other examples depending on the
nature of the business and the appropriateness of the asset account given the nature of business.

Assets are classified into two: Current and Noncurrent.

Current assets are assets which can be utilized, used or consumed within a period of one year
or the normal operating cycle whichever is longer. Noncurrent assets can be utilized, used or
consumed beyond one year. Examples are land, building, equipment, vehicles. These two
classifications are used primarily for financial reporting especially for financial analysis.

Examples of LIABILITY accounts (these are CREDIT accounts) are: Accounts payable, notes
payable, mortgage payable, salaries payable, utility expenses payable (communication,
electricity, water), mandatory payroll deductions from employees’ salaries, and the employer’s
counterpart on mandatory payroll deductions, unpaid taxes, etc.
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 Liabilities are also classified into current and noncurrent. Current liabilities are liabilities which
are payable within one year or the normal operating cycle. Noncurrent liabilities are liabilities the
settlement of which extends beyond one year.

Business transactions affecting the CAPITAL accounts are: the original or initial investment
made by the owner, additional investments, revenues such as gross receipts or gross income, gains,
and sales (these are CREDIT to capital accounts. All of these INCREASE the CAPITAL accounts.

Other business transactions affecting the CAPITAL accounts are: permanent or temporary
withdrawal of capital (Drawing account), business expenses, and losses. All of these DECREASE the
CAPITAL accounts.

Let’s take some examples to illustrate the effect of business transactions in the equation:

Assets invested by the owner

July 1, 2021 – Martin Reyes started today a delivery service business with the following
investments: cash, P800,000 and a car amounting to P200,000.

ASSETS = LIABILITIES + CAPITAL

Cash - P800,000 0 Reyes, Capital - P1,000,000
Vehicle - 200,000

Borrowings from the bank

July 2 – Reyes borrowed P100,000 cash from PNB for additional capital in his business.

ASSETS = LIABILITIES + CAPITAL

Cash - 900,000 Loans Payable - P100,000 Reyes, Capital - 1,000,000
Vehicle - 200,000

Asset purchased for cash

July 7 – Bought tables and chairs from The Orocan Trading and paid P45,000 cash.

ASSETS = LIABILITIES + CAPITAL

Cash - P855,000 Loans Payable - P100,000 Reyes, Capital - P1,000,000
Vehicle - 2200,000
Furniture - 45,000

Assets purchased on account

July 15 – Various equipment were purchased on account from Fortuna Trading for P55,000.

ASSETS = LIABILITIES + CAPITAL

Cash - P855,000 Loans Payable - P100,000 Reyes, Capital - P1,000,000
Vehicle - 200,000 Accounts Payable - 55,000
Furniture - 45,000
Equipment - 55,000

Cash withdrawal by the owner

July 18 – Reyes made a cash withdrawal of P5,000 for personal use.

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 ASSETS = LIABILITIES + CAPITAL
Cash - P850,000 Loans Payable - P100,000 Reyes, Capital - P1,000,000
Vehicle - 200,000 Accounts Payable - 55,000 Reyes, Drawing - (5,000)
Furniture - 45,000
Equipment - 55,000

Payment of liability

July 20 – Paid in full the account due to Fortuna Trading.

ASSETS = LIABILITIES + CAPITAL

Cash - P795,000 Loans Payable - P100,000 Reyes, Capital - P1,000,000

Vehicle - 200,000 Reyes, Drawing (5,000)
Furniture - 45,000
Equipment - 55,000

THE FINANCIAL STATEMENTS

Financial statements are written records that show the activities and the financial
performance of the business for a particular period.

The basic financial statements are as follows:

1. Statement of comprehensive income - this is traditionally known as the income
statement. This reports the revenues, costs, expenses, gains and losses of the business
entity.
2. Statement of financial condition or position - this is traditionally known as the balance
sheet. This reports the assets, liabilities, and capital (singly owned business).
3. Statement of Cash Flows - this is a financial report showing how cash was obtained and
utilized for that given period the report is intended.

4. Statement of Changes in Equity – this statement reports what transpired to the business
entity’s capital account, from the beginning of the period, during the period, and at the
end of the period. The word equity in this description refers to the owner’s capital
account as a single owner of the business.
5. Notes to Financial Statements - given the financial reports for a given period and as of a
given period the reports cannot provide the complete information for us to consider it is
complete as to adequate disclosure. Relevant qualitative information is provided in the
Notes to Financial Statements.

ELEMENTS OF FINANCIAL STATEMENTS

The elements of financial statements are assets (economic resources), liabilities (economic
obligations), and capital and its auxiliary accounts which are the drawing, revenues, gains,
expenses, and losses.

ASSETS - are defined as resources or things of value owned by the business, ”what the business own”.
They are classified as current, non-current, and intangible assets.

CURRENT ASSETS – are assets which can be sold, consumed, or converted into cash through the
normal operations of a business, usually within the period of one year.

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The following are the kinds of current assets:

1. CASH

Cash refers to the money owned by the business. Cash kept in the company’s premises is
called cash on hand. While the money of the business in the bank which can be kept in a saving or
checking account is called Cash in bank.

Strictly speaking, cash refers only to funds readily available to be spent for the business’
operations. It is used for buying assets, paying suppliers, utilities, employees’ salaries and others. It is
also used for settlement of obligations. On the other hand, cash are sourced from contribution of
owners (investment/capital), proceeds from borrowings (loans), sale of assets (sales) or collections
from customers (payment of debts).
Cash on hand includes paper bills, coins and bank checks kept in the premises of the
business. Bank checks, or checks, are bank documents used by the issuer to instruct the bank to pay
the assigned payee from funds in the issuer’s bank account. Checks must be reported as part of
cash because these documents are accepted as payments and deposits.
A check is classified as cash if the date of the check is on or before the SFP date. A check
dated after the SFP date is a post-dated check and is classified as receivable rather than cash. For
example, the date of the SFP is August 31, 2020. Any check that bears the date before or as of
August 31, 2020 that the business is holding is considered cash. But if as of August 31, 2020 the business
is holding a check dated September 1, 2020, that check cannot be considered as cash but a
receivable.
Not all bank deposits are classified as cash. Some accounts are not readily available for use
such as a time deposit account. A time deposit account is a deposit in the bank that earns higher
interest because the depositor commits not to withdraw the funds over the agreed upon time.
Penalties are imposed if the depositor withdraws before the maturity of the deposit. Given the
withdrawal restrictions, time deposits are not classified as cash. Those with a term of up to 90 days
are reported as cash equivalents while those that will mature longer than 90 days are reported as
investments.
Cash equivalents are technically not cash because it is not immediately available for use. It is
almost cash in the sense that it will become cash within the next 90 days. Time deposits with term
maturities of 90 days or less are examples of cash equivalents. It is generally reported on the SFP
together with cash. The line account is cash and cash equivalents. However, the components of
cash and cash equivalents (cash on hand, cash in bank, cash equivalents) are required to be
disclosed in the accompanying notes to financial statements.

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EXAMPLE:

Friendly Convenience Store: CASH

Friendly Convenience Store is managed by Juana Dela Cruz. Juana asked you to
determine the balance of her cash account as of December 31, 2020. You
determined the following:

1. She kept some cash in the store as change fund (sukli). The cash count revealed
3 pieces of 100-peso bills, 5 pieces of 50-peso bills, 5 pieces of 20-peso bills, 5
pieces of 10-peso coins, 10 pieces of 5-peso coins, 10 pieces of 1-peso coins and
25 pieces of 25-centavo coins.

2. Two of her regular customers gave Juana the following checks in payment of
debts:
a. ₱1,540 check dated December 31, 2020.
b. ₱2,432 check dated January 3, 2021.

3. There are two bank accounts in the name of the store with the following
balances:
a. Balance of the savings account on December 31, 2020 according to the
passbook is ₱26,780.
b. A time deposit certificate for ₱100,000 for 90-days.

Report to Juana Dela Cruz the balance of the cash and cash equivalents account of
Friendly Convenience Store.

ANSWER

Number of
Denomination Bills Peso Amount
₱100 3 ₱300.00
₱50 5 250.00
₱20 5 100.00
₱10 (coins) 5 50.00
₱5 (coins) 10 50.00
₱1 (coins) 10 10.00
₱0.25 (coins) 25 6.25 December 31, 2020
Checks 1,540.00
Total Cash on Hand 2,306.25
Cash in bank 26,780.00
Total Cash 29,086.25
Cash Equivalents: 100,000.00
Total Cash and Cash
Equivalents: ₱129,086.25

Notes:
1. The ₱2,432 check dated January 3, 2021 is a post-dated check. It is not
cash as of December 31, 2020.

2. The time deposit certificate for ₱100,000 for 90-days will not meet the
definition of cash. It is classified as cash equivalents.

2. RECEIVABLES
Receivables is a general term that refers to the business’ right to collect or claim payment
from the customer or another party. The right to collect comes from unpaid sales or lending activities.
Generally, the business collects cash from its receivables. There are also receivables that may be
settled in other assets or services. For example, receivable from suppliers may be settled in
merchandise.
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 A sale agreement may require a customer to pay the seller at some future time after delivery
of the merchandise. This is a credit sales agreement and it gives rise to Accounts Receivable,
normally referred to as AR. This account means receivable from customers. It is evidenced by sales
invoices and delivery receipts. Accounts receivable normally has a term of 30 days which means a
customer should pay within 30 days from the date of delivery. Some sellers are more lenient and
give terms of 60, 90 and 180 days.
Notes receivable is another kind of receivable. It is evidenced by promissory notes (PN). PN
is a legal document that says the borrower promises to pay, on scheduled payment dates, a
specific sum called the principal and interest based on principal and stated interest rate. Customers
who are unable to pay their accounts on due dates are sometimes required to sign a PN. The
business may also lend money to its employees or other companies if the company has excess cash.

EXAMPLE:

Friendly Convenience Store: ACCOUNTS RECEIVABLE

Juana asked you to compute how much Marie Reyes owned the store. Juana
sells to Marie on credit. Marie pays every 15th and 30th of the month. Marie’s listings
are given below:
Marie Reyes
September 5 2 bottles of cola (₱12 each)
September 15 1 bar of laundry soap (₱50)
October 3 1 sachet of fabric softener (₱50)
October 8 1 small can of sardines (₱25)
October 15 Payment: ₱200.00
October 25 2 bags of chips (₱30 each)

ANSWER

Marie Reyes
September 5 2 bottles of cola (₱12 each) ₱24.00
September 15 1 bar of laundry soap (₱50) 50.00
October 3 1 sachet of fabric softener (₱50) 50.00
October 8 1 small can of sardines (₱25) 25.00
October 15 Payment: ₱200.00 (200.00)
October 25 2 bags of chips (₱30 each) 60.00

3. INVENTORY

The Inventory account reports the cost of unsold merchandise. The Inventory account of a
trading business contains merchandise held for resale. A manufacturing company will have more
complex inventories composed of raw materials, unfinished inventories in the middle of the
manufacturing process (may also be called work in process), and unsold finished goods.

Consignment is an important issue in inventory accounting. The owner places his goods “on-
consignment” in the premises of the store owner. The store is not obligated to purchase the goods.
The owner may also withdraw his unsold goods from the store at any time. The store owner, on the
other hand, will remit to the merchandise owner the proceeds from the sales of the consigned items.
The store owner’s income from his transaction maybe in the form of commissions from the sale
and/or rent from the store space used to display the consigned goods. The store should not report
the consigned goods as inventory even if they are held in the store premises. Rather, the consigned
merchandise will be reported as Inventory by the merchandise owner.

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 Only merchandise held for sale are reported as Inventory. Those items that are to be used in
the day to day activities of the company are Supplies and not Inventory. For example, a convenience
store sells ballpens. The owner also uses ballpens in recording transactions in the store’s accounting
records. By definition, only those ballpens for reselling are reported as Inventory. Those that are to
be used in the business are classified as Supplies.

EXAMPLE:

Friendly Convenience Store: INVENTORY

Before Juana opened the store on January 1, 2021, she asked you to help
her count the merchandise inside the store. The results of the counting are the
following:

Merchandise Cost
2 bags of candy ₱30 per bag
10 sachets of coffee ₱6 per sachet
10 sachets of laundry powder ₱15 per sachet
1 sack of rice (50 kilos) ₱1,800 per sack
10 cans of sardines ₱15 per can
10 chocolate bars ₱20 per bar
5 notebooks ₱25 per notebook

Notes:
1. The chocolate bars were on consignment from Tsokolate.
2. Of the 5 notebooks inside the store, one is used for listings of customer
credit.

Report to Juana Dela Cruz the balance of the merchandise inventory account
of Friendly Convenience Store.

ANSWER

Merchandise Cost Total

2 bags of candy ₱30 per bag ₱60.00
10 sachets of coffee ₱6 per sachet 60.00
10 sachets of laundry powder ₱15 per sachet 150.00
1 sack of rice (50 kilos) ₱1,800 per sack 1,800.00
10 cans of sardines ₱15 per can 150.00
4 notebooks (see number 2 ₱25 per notebook 100.00
below)

Merchandise Inventory as of December 31, 2021. ₱2,320.00

Notes:
1. The 10 chocolate bars are not owned by the store. They are consignment
from Tsokolate.
2. Only 4 notebooks are for sale. One was used as office supplies in the store.

4. PREPAID EXPENSES

Prepaid expenses refer to future expenses that the business had paid for in advance. It is
placed in this account until the services or items are used/consumed and become expenses.
Let us look at mobile phone services. When prepaid subscribers purchase “loads” or “cards,”
Notes:
they essentially pay the phone companies prior to using their services. On the other hand, post-paid
subscribers 3.
payTheonly after they
10 chocolate barsare
arebilled for the
not owned services
by the used.
store. They are Accrual
consignmentaccounting dictates that
from Tsokolate-
Eh.
expense is recognized only when phone services are used, regardless of whether they are prepaid
4. Only 4 notebooks are for sale. One was used as office supplies in the store.
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or post-paid subscribers. The question now is how prepaid subscribers account for their load or card
purchases. Prepaid load/card is recorded in the Prepaid Expense account. When the load is
consumed, the cost of the card is removed from Prepaid Expense account and transferred to
Communications Expense.
Another kind of prepaid expense is insurance. The insured will pay premium at the beginning
of the contract period and the insurer (insurance company) will reimburse/repay the insured party
(the business) for losses if the insured event occurs.
For example, an annual fire insurance contract requires the insured party to pay premium at the
beginning of the contract year. During the contract period, if fire occurs at the insured premises,
then the insurance company will pay the insured for the amount of damages he suffered resulting
from the fire. However, the insurance company has no obligation to return the premiums paid by
the insured party if there is no fire during the contract period. So why do companies buy insurance
contracts? It is because premium payments are significantly lower than the amount of the estimated
damages that the company will burden if the insured event indeed occurs. A company buys
insurance contract to be prepared in case something happens, even if they hope that thing will
never happen.
Insurance contracts are time based. The buyer of the contract is insured only within the
contract period. This means that the advanced payment of the insured is at first a Prepaid Expense.
It is transferred to expense evenly over the contract period. Also, at the end of the contract period,
the entire advance payment should have been fully transferred to expense such that the balance
of the Prepaid Insurance is zero.

EXAMPLE:

Friendly Convenience Store: PREPAID EXPENSE

Juana paid premium of ₱2,500 for one-year fire insurance in the name of the
store on October 1, 2020. How much should the prepaid insurance be on
December 31, 2020?

ANSWER

Insurance premium is paid in advance. In the case of Friendly Convenience Store,

the ₱2,500 premium payment was for insurance from October 1, 2020 to September 30,
2021. As of December 31, 2020, 3 months had already passed and therefore
considered now as an expense. Therefore, only 9 months is Prepaid Expense.

We compute the Prepaid Insurance Expense as ₱2,500 X 9/12 = ₱1,875

NON-CURRENT ASSETS

Property, Plant, and Equipment or PPE for short, are used in the operations of the company.
These are classified as long-term assets (or non-current asset) because these assets will be used in
the business for more than one year. Examples of such assets classified as PPE are land, building,
warehouse, automobiles, delivery vehicle, computer equipment and manufacturing equipment.
Only those assets owned and controlled by the company will be reported as PPE. Rented facilities
and equipment are excluded from PPE.

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EXAMPLE:

Friendly Convenience Store: PROPERTY, PLANT, AND EQUIPMENT

On January 1, 2020, Juana purchased an electronic cash register to be used in

the Friendly Convenience Store. The cash register was purchased at a cost of
₱15,000. Juana depreciates the cash register over five years. Determine the
following:

1. Equipment
2. Annual depreciation
3. Accumulated depreciation as of December 31, 2021
4. Net book value of Equipment as of December 31, 2021

ANSWER

Cost of electronic cash register ₱15,000 (1)

Estimated useful life (in years) 5
Annual depreciation (₱15,000 / 5 years) ₱3,000 (2)
Number of years depreciated (2020 - 2021) 2
Accumulated depreciation (₱3,000 x 2) ₱6,000 (3)

Net book value ((₱15,000 - ₱6,000) ₱9,000 (4)

Net book value - represents the carrying value of assets reported on the balance sheet, and
is calculated by subtracting accumulated depreciation from the original purchase cost of the asset.
The net book value of an asset is essentially how much the asset is worth at a moment in time.
Depreciation - is an accounting method of apportioning the cost or price of a tangible or
physical asset over its useful life or life expectancy. It represents how much of an asset's value has
been used up. Depreciation may be caused also by unfavorable market conditions. Machinery,
equipment, currency are some examples of assets that are likely to depreciate over a specific period
of time.

INTANGIBLE ASSETS

Intangible Assets are long-term or non-current assets similar to PPE. These assets will be used
in the business for more than one year. These are assets that you cannot see or touch. Some
examples of Intangible Assets are patent, brand name, trademark, and copyright.

Patent is a grant conferred by the government to protect the creator of an invention, whether
a product or a process, for the sole right to make, use, and sell that invention for a specified period
of time.
Brand-name refers to word or words used to identify a specific product and its manufacturer.
Famous brands include Jollibee, McDonalds, Apple, Coca-Cola, Samsung, Sony, and Nike.
Trademark is the symbol that represents the brand. Take the case of the happy red bee that
represents the Jollibee, the tall clown in stripes of McDonalds and the swoosh checkmark of Nike.
Copyright – is the legal right to be the only one to reproduce, publish, and sell a book, musical
recordings, videos, etc. for a certain period of time.

LIABILITIES - refer to the present debts or obligations of the business to pay cash or cash equivalents
to its creditors. “What the business owed”. They are classified as
current and non-current liabilities. Payment for liabilities may be in cash, goods, or services.

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 The following are the kinds of current liability:
1. Payables

Payables are obligations to make payments to creditors. There are generally two kinds of
payables – Accounts Payable and Notes Payable.
Accounts Payable normally refers to obligation to the suppliers of inventories. It is evidenced by the
supplier’s sales invoices and delivery receipts. Most suppliers give credit terms of 30 to 90 days. A
30-day credit term means that the company should pay for the purchases within 30 days from the
date of delivery. Some suppliers give discounts for early payments. The credit term 2/10, n/30
(reads: two ten net thirty) means payment of full amount is due in 30 days but a 2% discount may
be taken if the account is paid within ten days (after delivery). This kind of credit term encourages
debtors to pay earlier than their due dates.

EXAMPLE:

Friendly Convenience Store: ACCOUNTS PAYABLE

On November 15, 2020, Juana Dela Cruz purchased five sacks of rice at ₱1,800
per sack. The credit term is 2/10, n/30. Determine how much Juana should pay
given the following payment dates:
1. November 25, 2020
2. December 15, 2020

ANSWER

1. If Juana will pay anytime from November 15, 2020 to November 25, 2020,
payment due is:

Full cost of one sack of rice ₱1,800

Number of sacks purchased 5
Total cost of purchase 9,000
Discount in % 2%
Discount in Peso 180
Discounted cost to be paid ₱8,820

2. If Juana will pay after November 25, 2020, she will have to pay the full cost of
₱9,000. She will forego the savings of ₱180.

Notes payable refers to a debt or obligation evidenced by a promissory note. Promissory Note
is a document that expresses the borrower’s promise to pay. The issuer of the promissory note reports
this as Notes Payable in his accounting books. On the other hand, the holder of the promissory note
has the right to collect and reports Notes Receivable in his accounting books.

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EXAMPLE:

Friendly Convenience Store: NOTES PAYABLE

Read the excerpt of the Promissory Note below:

Promissory Note

November 1, 2020

1. Promise to Pay. For value received, Friendly Convenience Store, represented by

Juana Dela Cruz, the manager, (Borrower) promises to pay United Bank (Lender)
₱25,000 (Twenty-five thousand pesos) and interest at the yearly rate of 6% on the
unpaid balance as specified below.
2. Installment. Borrower will pay five payments of ₱5,000 each at monthly intervals on
the 30th day of the month. First payment is due on November 30, 2020.
3. Application of Payments. Payments will be applied first to interest and then to principal.
4. Prepayment. Borrower may prepay all or any part of the principal without penalty.
5. Loan Acceleration. If Borrower is more than five days late in making any payment,
Lender may declare that the entire balance of unpaid principal is due immediately,
together with the interest that has accrued.

Answer the following questions:

1. Who will record the Notes Payable?

2. Who will record the Notes Receivable?
3. Compute for the payment due on November 30, 2020 and December 30, 2020.
4. Determine the balance of Notes Payable as of December 31, 2020.

ANSWER

1. According to the Promissory Note, the borrower is Friendly Convenience Store.

Therefore, a Notes Payable will be reflected on the SFP of the store.

2. According to the Promissory Note, the lender is United Bank. A Note Receivable will
be reflected on the SFP of the bank.

3. Payment due on the following dates:

November 30, 2020 December 30, 2020

Unpaid balance, beginning ₱25,000 ₱20,000
Stated interest 6% 6%
Interest period* 1/12 1/12
Interest to be paid 125 100
Monthly principal payment 5,000 5,000
Payment due ₱5,125 ₱5,100

* Stated interest of 6% is expressed on a per annum basis. It means 6% per 12

months period. To get interest for the month, it is 6% / 12 months.

4. The balance of Notes Payable on December 31, 2020 is ₱15,000. Following the payment
schedule, Juana should have already made two payments of ₱5,000 each as of
December 31 (November and December). Hence, the remaining unpaid balance is
(₱25,000 - ₱10,000) ₱15,000.

2. Accrued Expenses

Let us recall our earlier discussion about prepaid mobile phone loads and post-paid plans.
Mobile phone loads are advance payments for future usage of mobile phone services. On the other
hand, post-paid service subscribers are billed for their usage of the service. The billing statement also
states when payment is due. Post-paid service plans are accounted for as Accrued Expense until

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payment is made to the phone company.
Accrued Expense refers to the unpaid expenses of the company as of the cut-off date of the
Statement of Financial Position. There are many kinds of accrued expenses such as Salaries Payable,
Utilities Payable, Rent Payable and Interest Payable. Take the case of the following payroll schedule.
Employees are paid every 15th and 30th day of the month. Salary paid on the 15th is work rendered
by the employees for the 29th day of the current month to 13th day of the following month while that
paid on the 30th is for work rendered for 14th to 28th day of the same month. As of December 31
(calendar year SFP), the company would have owed the employees for three days of work,
December 29-31. According to the payroll schedule, these days will be paid as part of their January
15 payroll. Therefore, Salaries Payable should reflect the three days of unpaid salaries.

EXAMPLE:

Friendly Convenience Store: ACCRUED (Salary) EXPENSE

Juana hired Elena Reyes as storekeeper with a salary of ₱400 per day. Elena is paid
every Saturday for work rendered during the week. Sunday is her day-off. Supposing
that December 31, 2020 falls on a Thursday. Determine the balance of Salaries
Payable to be reported on the Store’s SFP as of December 31, 2020.

ANSWER

Daily salary rate ₱400

Number of unpaid days (Tuesday to 3
Thursday)
Salaries payable, December 31, 2020 ₱1,200

3. Unearned Income

Unearned income are deposits or down payments received by the business from its customers
before the delivery of goods or services. These will not count as sales until deliveries are made. These
payments are initially recorded as Unearned Income – a liability payable in goods or services.
Take the case of a tailor of custom-maid suits. He requires his customer to pay a down
payment upon ordering. The tailor does this because (1) the money received from the customer will
be spent on materials for the suits; and (2) the significant payment made by the customer will ensure
that he will return to claim his order and pay the full price. Can the tailor record a revenue based on
the amount of down payment received from the customer? The answer is NO. He can only record
revenue when the suits are delivered to and accepted by the customer. While these activities are
not yet done, the cash received from the customer is reported as unearned income. Upon delivery
and acceptance, the unearned income is transferred to revenue.

Unearned income is a liability. However, unlike regular liability, the settlement of unearned
income is not through direct cash payments to the customer. Rather, it is settled by the delivery of
goods or rendering of services. The settlement of this liability is dependent on the contractual
agreement between the seller and the buyer. In the case of the tailor, it is job based. However, some
contracts are time based. An example of this is advance rent.

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EXAMPLE:

Friendly Convenience Store: UNEARNED

INCOME

Pedro Benitez, a neighbor of Juana, operates a coffee bending machine business.

On October 1, 2020, he entered in a contract with Juana to rent a small space on the
counter-top of the Store where he can put his coffee bending machine. The rent is
₱500 per month. Pedro paid six months advance rent on October 1, 2020. How much
should be reflected as Unearned Rent Income on the Store’s SFP as of December 31,
2020?

ANSWER

Monthly rental rate ₱500

Remaining unused months (January to March) 3
Unearned Rent Income, December 31, 2020 ₱1,500

Note: 3 months have been consumed (October to December

2020) and should be recorded as revenue.

NON-CURRENT OR LONG-TERM LIABILITIES

Long-Term Liabilities refer to obligations with due dates that fall more than one year from the
date of the accounting period (Mortgage Payable). They are considered as non-current liability.
Bank loan is a common example. It is documented by a promissory note. The company (business)
pays interest periodically. The repayment of the principal is based on the contractual agreement. It
can all be paid at maturity or in instalment over the term of the loan. Long-term liability is part of the
financing activities of the company.

CAPITAL
Capital refers to the residual amount after deducting liabilities from assets. It comprises the
capital contribution/investment and withdrawals of the owner.

For a sole proprietorship, the SFP will reflect only one equity account – Owner’s Capital. This
one line account reflects all transactions of the business with its owner. This account will reflect the
balance of the owner’s investments in the business such as cash distributions. The net income earned
by the company is also closed to the capital account. While a separate Drawings account may be
maintained to follow the withdrawals of the owners during the year, this too, is closed to the capital
account at the end of the year.

EXAMPLE: If Juana Dela Cruz invested P250,000 pesos in her business from her personal money,
that amount is considered as capital.

The auxiliary accounts of CAPITAL are drawing, revenues, gains, expenses, and losses.

EXAMPLE OF DRAWING: When Juana Dela Cruz borrowed P5,000.00 from the business for her
personal use.
EXAMPLES OF REVENUE: The income earned from the sale of merchandise (for merchandising
business), services rendered (for servicing business), and professional
fees (usually for lawyers, tutors, and the like).
EXAMPLES OF EXPENSE: Salary expense, maintenance expense, rent expense, insurance
expense, transportation expense, and many other expenses that the
business may incur.
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LESSON 2: THE ACCOUNTING PROCESS

The accounting cycle, also commonly referred to as accounting process, is a series of

procedures in the collection, processing, and communication of financial information. As defined in
Module 1, accounting involves recording, classifying, summarizing, and interpreting financial
information. Financial information is presented in reports called financial statements. But before they
can be prepared, accountants need to gather information about business transactions, then record
and collate them to come up with the values to be presented in the reports.
The cycle does not end with the presentation of financial statements. Subsequent steps are
needed to be done to prepare the accounting system for the next cycle.

The steps in the Accounting cycle are the following:

1. Identifying and Analyzing Business Transactions
2. Recording in the Journals
3. Posting to the Ledger
4. Unadjusted Trial Balance
5. Adjusting entries
6. Adjusted Trial Balance
7. Preparing Financial Statements
8. Closing Entries
9. Post-Closing Trial Balance
10. Reversing Entries (Optional)

This lesson will focus only on the first step, that is identifying and analyzing business transactions.
We will also measure the given transactions in terms of money values. Other steps will be discussed
in the succeeding modules.

What is Business Transaction?

- Business transaction is the exchange between two parties of things and rights, the values of
which are expressed in terms of pesos.
The two parties involved in a business transaction are:
1. The business. The business is always present in every transaction.
2. Other parties, like the buyer/customer, creditor, debtor, owner, employees and
other parties that have transactions with the business. They are not always present
in all business transactions.

Business transactions are exchanges of equal monetary values. This definition implies the
following concept of understanding:
1. For every value received, another value is given away as an exchange;
2. These values are measured in terms of pesos which are presumed to be equal.

In every transaction, there is a Value Received and the Value Parted With. This is the “give
and take” process of accounting as expressed in an equation:

Value received Value parted with

Debit Credit

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 A debit represents the value received in a transaction, while a credit represents the value
parted with. The debit and credit side should always be equal in every transaction.

HOW ARE BUSINESS TRANSACTIONS ANALYZED?

Business transactions are analyzed from the point of view of the business. If the transaction is
“Purchased” or “Bought”, it is the business that is buying; if the transaction is “Sold”, it is the business
that is selling; if the transaction is “Paid”, it is the business that is paying; if the transaction is
“Collected”, it is the business that is collecting; if the business is “Rendered Services”, it is the business
that is rendering services, etc. and not the other way around. Don’t forget this, “always consider
yourself as the business” when making the analysis.

The value received or debit should first be determined before the value parted with or credit.
To test your analytical ability on transaction analysis, let us have a drill. Let us try this:

“If I will give you a piece of chalk and you will give me an eraser, in return as an
exchange, can you determine the value received and the value parted with?

If your answer is the value received is a piece of chalk and the value parted with
is an eraser, you have answered it correctly. You will then say, “Debit a piece of
chalk and Credit, eraser”

Let us have this illustration:

“Bought a car for cash, P650,000”
The following questions are answered for your guide.

1. Who bought the car?

Answer: the business.
2. What is the value received?
Answer: car
3. What is the value parted with?
Answer: cash – money
4. What is the peso equivalent of these exchanges?
Answer: P650,000
We then say,
Debit, (value received) – Car – P650,000
Credit, (value parted with) – Cash – P650,000
Let’s apply it on the examples of business transactions given in the table below.

Business transactions Value Received Value Parted With

(Debit) (Credit)
Bought supplies from a supplier Supplies Cash
for cash.
Bought supplies from a supplier on Supplies Promise to pay
account.
Bought a computer set for Computer set Cash
the business.
Sold products to a customer for Cash Products
cash.
Sold products to a customer Right to collect Products
on account.
Received cash for service rendered Cash Service rendered
to a customer.

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THE RULES OF DEBIT AND CREDIT

The accounting equation ASSETS = LIABILITIES + CAPITAL, is telling us that the sum of all asset
values is equal to the sum of all amounts of the business entity’s liabilities plus the balance of its
capital (owner’s equity, proprietorship, net assets, net worth- as a singly-owned business entity). This
means further that any change that may transpire on any element of the accounting equation, the
results should always be a balanced equation. This must be true from the initiation of business from
the very first business transaction up to any cut-off date we will assign to render financial reports.
It is because of the concept of the “dual entry system” or the double entry bookkeeping the
preceding paragraph must hold true. This concept tells us that for any quantifiable business
transactions or events, an increase in asset can have the following possible effects: increase in
liabilities, increase in capital, or decrease in another form of asset. A decrease in assets can have the
following possible effects: decrease in liabilities, decrease in capital, or increase in another form of
liability.

To further grasp what is being said from the preceding paragraphs let us consider the
following:
Figure 1. The accounting equation and the elements’ normal balances.

Let us further discuss the preceding presentations:

Under Assets
Examples of ASSET accounts (these are DEBIT accounts) – Cash, Accounts receivable, Unused
supplies, merchandise inventory, Land, Building, Office equipment, Furniture and Fixtures, and many
other asset accounts you can think of.
This is telling us that when an ASSET account is acquired, it is DEBITED when the journal entry
to record it is made and recorded. It increased the LEFT SIDE (debit) of the accounting equation. So,
because of the dual entry system it must have a corresponding effect on the RIGHT SIDE (credit) of
the accounting equation, but details for this will not be given for the meantime.

Under Liabilities
Examples of LIABILITY accounts (these are CREDIT accounts)—Accounts payable, notes
payable, mortgage payable, salaries payable, utility expenses payable (communication,
electricity, water), mandatory payroll deductions from employees’ salaries, and the employer’s
counterpart on mandatory payroll deductions, unpaid taxes, and many others.
This is telling us that when a LIABILITY is incurred, a liability account is CREDITED when the
journal entry to record it is made and recorded. It increased the RIGHT SIDE (credit) of the
accounting equation. So, because of the dual entry system it must have a corresponding effect on
the LEFT SIDE (debit) of the accounting equation.

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Under CAPITAL on Investments
The word investment here may refer to the initial (original) investment put into the business by
the owner. The investments may be in the form of cash or non-cash assets. Additional investment
may be desired by the owner depending on the progress of his business. When initial or additional
investment is made, the CAPITAL account is CREDITED (this INCREASED the capital account in the
accounting equation.

Under CAPITAL on Withdrawals

The owner of the business may make temporary withdrawals from the business such as cash
or non-cash assets. This DECREASES the CAPITAL in the accounting equation.
To record this, a Drawing or Personal account is DEBITED. Note that the CAPITAL account is not
directly used because it is temporary. Usually withdrawals by the owner are made in anticipation of
profits.

Under CAPITAL on Revenues

The word revenue generally refers to the cash inflows received by the business out of its
primary business activities. To be specific, the cash received by a haircutter in his hair styling business
can be in broad term called revenue but it can be appropriately or specifically labeled as “gross
receipts”. The amount received by a dry goods seller say a pair of shoes is “revenue” but in a
merchandising business it can appropriately be labeled as “gross sales”. A possible “net gain” on
sale of a second-hand vehicle is a “revenue” but can specifically and appropriately termed as
“gain on sale of transport equipment”.
All that has been stated from the preceding paragraph as REVENUES INCREASE the CAPITAL
in the accounting equation. So, when REVENUES are recognized and recorded their appropriate
accounts are CREDITED.

Under CAPITAL on Expenses

The business in its primary motive to earn profit should generate revenue but business
expenses are necessary to attain this.

The expenses must be business related. The term “expenses” is a broad term to be used as
an account. The naming of an expense account depends on the nature of the business. Meaning
the appropriateness of the use of the account in relation to the kind of the business it is engage in.
In our study of this subject we will initially example service concern businesses.

But how do expenses affect the accounting equation? An EXPENSE account DECREASE the
CAPITAL in the accounting equation. So, when an expense is incurred, an EXPENSE account is
DEBITED.

We will now derive a summary for the rules on debit and credit. Let us again consider the
following presentations:

The following are the location of debit and credit in the “T” accounts of assets, liabilities,
and capital and their corresponding increases and decreases:

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 Here now are the RULES OF DEBIT AND CREDIT based on the illustration:

1. Debit all increase in asset accounts; Credit all decrease in asset accounts.
2. Credit all increase in liability accounts; Debit all decrease in liability accounts.
3. Credit all increase in capital and revenue accounts; Debit all decrease in
capital and revenue accounts.
4. Debit all increase in withdrawal and expenses accounts; Credit all
decrease in withdrawal and expenses accounts.

ANOTHER PRESENTATION CAN BE:

So, let’s analyze business transactions applying the rules of debit and credit.

Transaction 1:
The business bought equipment for cash from Green Corporation, P100,000.

Analysis:

In this transaction, the asset of the business, which is equipment, increased. However,
another asset, which is cash, decreased.

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 We then say,

Debit Equipment P100,000

Credit Cash P100,000

Transaction 2:
Rendered service to a customer in cash, P500.

Analysis:

In this transaction, the asset of the business, which is cash, increased. In a servicing
business, the payment for the service rendered increases the income or revenue.

We then say,

Debit Cash P500

Credit Revenue P500

SOURCE DOCUMENTS

Every business transaction must be supported with documents in order to verify its
accuracy. The following are examples of documents that serve as sources or bases of the basic
recorded entries (especially cash receipt or cash paid) given one accounting period.

1. OFFICIAL RECEIPT
A document issued by the receiver of cash
which may represent payment for goods bought
from the receiver or service availed from the
receiver. As a source document this is the evidence
(supporting document) or basis to record cash
received by the business entity. Receiving cash as
payment for a cash sale of goods or service or
payment of a previous sale of goods or service on
account.

2. CASH SALES INVOICE

A document issued to a customer for goods
bought and paid in cash by the customer. As a
source document this is the evidence (supporting
document) to record sale of goods on cash basis.
Receiving cash and recognizing cash sales of
goods.

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3. CHARGE SALES INVOICE OR CHARGE INVOICE
A document issued to a customer for goods bought
or services availed of but not yet paid by the customer. As
a source document this is the evidence (supporting
document) to record a collectible from a customer and on
the part of the business entity to recognize revenue on an
account basis.

4. JOURNAL VOUCHER

In accounting this is used as a basis to record a

transaction generally not involving cash. Like
recording a provision for depreciation for an
accounting period, among many others, like
corrections and adjustments.
As a source document, this authorizes the
accounting personnel to make entries in the
books of the business entity.

(Note: The above are just examples of the basic documents the business entity issues and can also
receive. There are a lot of other business forms which we consider as source documents related to
the primary business activities happening daily to the business entity which can indirectly support
quantifiability of business activities.)

BOOKS OF ACCOUNT

The phrase “books of accounts” is the term generally used to mean the set of records being
maintained by a business entity in regard to all its economic activities. Entries in the books of
accounts are required to be supported with documents such as official receipts, sales invoices,
vouchers and other related supporting documents evidencing the business transactions occur. All
persons engaged in trade or business, or in the practice of profession registered with the Bureau of
Internal Revenue (BIR) are required to maintain books of accounts. Failure to maintain books of
accounts is subject to penalties.

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 The Books of Accounts are with ready or prepared design to fit the need of the business and
also to provide convenience for the accountants in pursuing the primary objective of accounting
which is communication through the Financial Statements.

There are two sets of books that are used by the business. They are the book of original entry
and the book of final entry.
The book of original entry is called JOURNAL which is of two kinds; the GENERAL JOURNAL and
the SPECIAL JOURNAL. This is called the book of original entry because it is in this book where
transactions are recorded for the first time.
The book of final entry is called the LEDGER which is also of two kinds; the GENERAL LEDGER
and the SUBSIDIARY LEDGER. This is called the book of final entry because it is in this book where
transactions that were recorded in the Journal are transferred for final recording.

GENERAL JOURNAL
A General Journal can that be of a loose-leaf or book-bound form. It has the following
columnar headings:
DATE COLUMN – shows the date when the transactions took place.
PARTICULARS – shows the item or the accounts debited or credited as a result of a transaction
analysis as well as a brief or concise explanation of what the transaction is about.
FOLIO – shows the number of an account in a ledger or page of a ledger to which it was
transferred. Folio is the Latin word for page. It is also called a reference.
DEBIT COLUMN – this is a money column showing the peso amount of the value received in a
transaction.
CREDIT COLUMN – this is a money column showing the peso amount of the value parted
with in a transaction.

Shown below is a page of a General Journal:

Account No. _______

Year Particulars F Debit Credit
Month Day

NOTE: Amounts entered in the General Journal are not totaled.

GENERAL LEDGER
A general ledger can also be of a loose leaf or book bound form. This book is composed of
a group items or accounts of the same kind, class or nature. Each item or account is being
provided with a leaf of a ledger. For this reason, a ledger is also called group of accounts.

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Example of a general ledger:

Shown below is a page of a GENERAL LEDGER:

Account No.______
Year Particulars F Debit Year Particulars F Credit
Month Day Month Day

At the end of accounting period, the debit and credit entries of its item or account in the
ledger are totaled. If the debit side total is bigger than the credit side total, the difference in amount
is called DEBIT BALANCE. We then say, the account is a debit balance. On the other hand, If the
credit side total is bigger than the debit side total, the difference in amount is called CREDIT
BALANCE. We then say, the account is a credit balance. If both totals of debit and credit sides are
equal, the account is said to be INBALANCE or CLOSED ACCOUNT.

REFERENCES:

Beticon, Josefina Loria. Domingo, James Christopher. Yabut, Fermin Antonio. (2016 Edition)
Fundamentals of Accountancy, Business, and Management 2. 1253 G. Araneta Avenue,
Quezon City. Vibal Group, Inc.

Lopez, Rafael Jr. M. (2016 Edition). Fundamentals of Accounting (Simplified Procedural

Approach). Davao City, Philippines: MS LOPEZ Printing & Publishing

[Link]
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