Saint Theresa College of Tandag, Inc.
COLLEGE OF ACCOUNTANCY
Tandag City, Surigao del Sur
FINANCIAL
ACCOUNTING and
REPORTING
Module Topics
Chapter 3 The Accounting Equation
The Elements of Financial Statements
Topic 1 | The Accounting Equation
Intended Learning Outcomes: At the end of the unit the students must have:
1. Defined each of the elements of financial statements and used those definitions in determining the existence of an
asset, liability, equity, income and expense.
2. Identified and described the five major accounts.
3. Applied the classification of the elements of financial statements in analyzing business transactions.
4. Applied the accounting equation in solving accounting problems.
FINANCIAL STATEMENTS
Financial statements are written records of a business's financial situation. They stand as one of the more essential
components of business information, and as the principal method of communicating financial information about an
entity to meet the common needs of many diverse users.
COMPLETE SET OF FINANCIAL STATEMENTS
COMPONENTS OF FINANCIAL STATEMENT
FUNCTIONS/DEFINITIONS
Statement of Financial Position (SFC)
A formal statement showing the three
elements comprising financial position, namely
asset, liabilities and equity.
Income Statement (IS)
A formal statement showing the financial
performance or profit or loss of an entity for a
period of time.
Statement of Comprehensive Income (SIC)
A formal statement showing the financial
performance or profit or loss of an entity for a
period of time plus or minus the components of
other comprehensive income.
Statement of Changes in Equity (SCE)
A formal statement showing the movements in
the elements or components of the equity.
Statement of Cash Flow (SCF)
A component financial statements that
summarizes the operating, investing and
financing activities of an entity.
Notes to Financial Statements, comprising a
summary of significant accounting policies and
other explanatory information (NTF)
This statement provides narrative description or
disaggregation of items presented in the
financial statements and information about
items do not qualify for recognition but
enhances the understandability of the users.
ELEMENTS OF FINANCIAL STATEMENTS
FINANCIAL POSITION
ASSETS
Probable
future
economic
benefits
obtained or
controlled by
a
particular
LIABILITIES
OWNER’S EQUITY
entity as a
result of past
transactions or
events.
INCOME STATEMENT
Probable
future
the assets of an entity that remains
the future as a result of past
after deducting its liabilities.
transactions or events.
sacrifices of economic benefits
arising from present obligations of a
particular entity to transfer assets or
The residual
provide services to other entities in
interest in
EXPENSES
Profit or Loss
INCOME
Increases in assets, or
decreases in
liabilities, that result
in increases in equity,
other than those
relating to
contributions from
holders of equity
claims.
Decreases in assets,
or increases in
liabilities, that result
in decreases in
equity, other than
those relating to
distributions to
holders of equity
claims.
THE ACCOUNT
The basic summary device of accounting is the account. It is a record in the general ledger that is used to sort and store
business transactions. In other words, The Account is a detailed record of the increase, decrease and balance of each
element that appears in the statement of financial position and in the statement of financial performance. It has
similarity to the letter “T”.
ACCOUNT TITLE
Right side or CREDIT Side
Left side or
DEBIT Side
THE ACCOUNTING EQUATION
The accounting equation is the basic tool of accounting. It represents the relationship among the liabilities, assets, and
owner’s equity of a business. It is the foundation of double entry principle in accounting system. Double entry principle
indicates that the total debits are equal to the total credits for any transaction. Incorporate with that principle, the
equation displays that all assets of an entity are either financed by borrowings or the company’s owner/s.
The mathematical expression of the accounting equation is:
A
ASSETS
L
OE
LIABIITIES
OWNER’S
EQUITY
Note that the assets are on the left side of the equation oppose the liabilities and owner’s equity. The logic of debit and
credit is related to the accounting equation. Thus, in all cases equality on both sides of the equation must be maintained.
Example: ASSETS = LIABILITIES + OWNER’S EQUITY
A. 100,000 = 50,000 + 50,000
B. ? = 90,000 + 60,000
C. 200,000 = ? + 90,000
Accounting equation can be expressed also using this expanded formula:
ASSETS = LIABILITIES + OWNER’S EQUITY
Assets
Liabilities
Owner’s Equity
OI - OE + I - E
Current
Assets
Non
Current
Assets
Current
Liabilities
Non-Curre
nt
Liabilities
DEBIT
(Dr.)
DEBIT
(Dr.)
CREDIT
(Cr.)
CREDIT
(Cr.)
Owner’s
Investments
CREDIT
(Cr.)
Owner’s
Withdrawals
DEBIT
(Dr.)
Income
Expense
CREDIT
(Cr.)
DEBIT
(Dr.)
NORMAL BALANCE OF AN ACCOUNT
The normal balance of any accounts refers to the side of the account – debit or credit – where every increase is
recorded. 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 Balance INCOME STATEMENT ACCOUNTS
Debit for
Decrease in owner’s equity
Credit for
Increase in owner’s equity
ASSETS LIABILITIES AND OWNER’S EQUITY Debit Credit Debit Credit
(+) (-) (+) (-) Increases Decreases Decreases Increases
Normal Balance Normal Balance
Here is another way of summarizing the rules:
ACCOUNTS
Debit Credit
Increase in Increase in
Assets Liabilities
Expenses Owner’s Investments
Income
Decreases in
Liabilities Decreases in
Owner’s Withdrawals Assets
Income Expenses
TYPICAL ACCOUNT TITLES USED
BALANCE SHEET
An entity must normally present a classified statement of financial position, separating current and non-current assets
and liabilities, unless presentation based on liquidity provides information that is reliable. In either case, if an asset
(liability) category combines amounts that will be received (settled) after 12 months with assets (liabilities) that will be
received (settled) within 12 months, note disclosure is required that separates the longer-term amounts from the 12month amounts.
ASSETS
Current assets are assets that are:
∙ expected to be realized in the entity's normal operating cycle;
∙ held primarily for the purpose of trading;
∙ expected to be realized within 12 months after the reporting period; and
∙ cash and cash equivalents (unless restricted).
All other assets are non-current. Operating cycle is the time between the acquisition of materials entering into a process
and its realization in cash or an instrument that is readily convertible to cash.
CURRENT ASSETS
CASH. Cash comprises of cash on hand and demand deposits that are unrestricted for immediate use.
CASH EQUIVALENTS. Cash equivalents are short-term, highly liquid investments that are readily convertible to known
amounts of cash and which are subject to an insignificant risk of changes in value.
NOTES RECEIVABLE. Notes receivable are claims supported by formal promises to pay usually in the form of notes.
ACCOUNTS RECEIVABLE. Accounts receivable are open account arising from the sale of goods and services in the
ordinary course of business and not supported by promissory notes.
INVENTORIES. Inventories are assets held for sale in the ordinary course of business, in the process of production for
such sales or in the form of materials or supplies to be consumed in the production process or in the rendering of
services.
Three Major Type of Businesses
Categories of Inventory
1. Service
Supplies
Work in Progress
2. Merchandising
Supplies
Merchandise Inventory
3. Manufacturing
Raw Materials Inventory
Work in Process Inventory
Finished Goods Inventory
PREPAID EXPENSES. These are expenses paid for the business in advance. These items represent future economic
benefits until the time these start to contribute to the earning process; these, then, become expenses.
NON-CURRENT ASSETS
PROPERTY, PLANT AND EQUIPMENT (PPE). These are tangible assets that are held by an enterprise for use in the
production or supply of goods or services, or for rental to others, or for administrative purposes and which are expected
to be used during more than one period. Included are such items as Land, Building, Machinery, Equipment, Furniture and
Fixtures, and Service Vehicle.
ACCUMULATED DEPRECIATION. It is a contra account that contains the sum of all periodic depreciation charges. The
balance of this account is deducted from the cost of the related asset (PPE except for the Land) to obtain the book value
at the of the accounting period.
INTANGIBLE ASSETS. These are identifiable, nonmonetary assets without physical substance. These assets are controlled
by the entity as a result of past events (for example, purchase or self-creation) and from which future economic benefits
(inflows of cash or other assets) are expected.
LIABILITIES
Current liabilities are those:
∙ expected to be settled within the entity's normal operating cycle
∙ held for purpose of trading
∙ due to be settled within 12 months
∙ for which the entity does not have an unconditional right at the end of the reporting period to defer settlement
beyond 12 months.
Other liabilities are non-current.
CURRENT LIABILITIES
NOTES PAYABLE. Notes payable are unconditional promise in writing made by one person to another, signed by a maker,
engaging to pay demand or a fixed or determinable future time a sum certain in money to order or to bearer.
ACCOUNTS PAYABLE. These are unsecured claims from the entity for the goods and services received by the entity on
credit basis.
ACCRUED EXPENSES. These items represent a company's obligation to make future cash payments for the services or
expenses already incurred but not yet paid.
UNEARNED REVENUES. Unearned revenues are money received from a customer for work or services that has not
yet been performed.
CURRENT PORTION OF LONG-TERM DEBT. These are portions of mortgage notes, bonds and other long-term
indebtedness which are to be paid within one year from the end of the reporting period.
NON-CURRENT LIABILITIES
MORTGAGE PAYABLE. This account records long-term debt of the business entity for which the business entity has
pledged certain assets as security to the creditor.
BONDS PAYABLE. Bonds payable are formal unconditional promise, made under seal, to pay a specified sum of money at
determinable future date, and to make periodic interest payment at a stated rate until the principal sum is paid.
OWNER’S EQUITY
OWNER’S CAPITAL. This account is used to record the initial and additional investments of the owner of the business
entity. It is increased by the amount of profit earned during the period and is decreased by a loss. It is decreased by any
amount of cash and other assets that the owner may wish to withdraw from the business. This account title bears the
name of the owner.
Three Basic Form of Business
Ownerships
Categories of Equity
1. Sole Proprietorship
Owner’s Equity
2. Partnership
Partners’ Equity
3. Stock Corporation
Shareholders’ Equity
OWNER’S WITHDRAWALS. When the owner of the entity temporarily withdraws cash or other assets, this event is
recorded in the drawing or withdrawal account. However, permanent withdrawals will be recorded as a direct reduction
the owner’s capital account.
INCOME SUMMARY. It is a temporary account used at the end of the accounting period to close the income and expense
accounts. This account will show the profit or loss for the period before closing to the owner’s capital account.
INCOME STATEMENT
INCOME. Income comprises all cash inflows (exceptfor cash inflows from financing and investing activities of the
business) and claims from customers or clients as a result or past performance of services or sale of goods including
gains from sale of company’s assets and favorable settlement of company’s liabilities.
SERVICE REVENUES. Income earned from the performance of services to a particular customer or
client. SALES REVENUES. Income earned as a result of sale of goods to a particular customer.
GAINS. Income earned from incidental operation of the business.
EXPENSES. Expenses comprise all cash outflows (except for cash outflows from financing and investing activities of the
business) and all unpaid-unrecorded claims from the sellers of services to the company including losses (from sale of
company’s assets and unfavorable settlement of company’s liabilities) and other non-cash expenses such as depreciation
expense and doubtful account expense.
COST OF SALES. These are expenses incurred in relation to the sale of goods produced by the company.
LOSSES. Expenses incurred from incidental operation of the business.
SUMMARY:
ELEMENTS
OF FS
Account Titles
Normal
Balance
Increases
recorded by
Decreases
recorded
FS
Debit
Current
Assets
Credit
Debit
Credit
X
X
X
SFP
SCF
Trade and Other
Receivables:
∙ Notes Receivable
∙ Accounts Receivable
X
X
X
SFP
X
X
X
SFP
Inventories
X
X
X
SFP
Prepaid Expenses
X
X
X
SFP
Property plant and
Equipment
X
X
X
SFP
Accumulated Depreciation
Intangible Assets
Current
Liabilities
Debit
Cash and Cash Equivalents
Allowance for
Doubtful Accounts
Non-Curre
nt Assets
Credit
X
X
Trade and Other
Payables: ∙ Notes
Payable
∙ Accounts Payable
∙ Accrued Expenses
∙ Unearned Revenues
X
X
X
X
SFP
X
X
SFP
Current Portion of
Long Term Debt
X
X
X
SFP
Non-Curre
nt
Liabilities
Non-Current Portion
of Long-Term Debt
∙ Mortgage Payable
∙ Bonds Payable
X
X
X
SFP
Owner’s
Equity
Owner’s Capital
X
X
X
SFP
SCE
X
X
A
C
C
O
U
N
T
S
SFP
X
Owner’s Withdrawals
P
E
R
M
A
N
E
N
T
X
SCE
T
A
E
Income Summary
C
Income
∙ Service revenue
∙ Sales Revenue
∙ Gains
X
X
X
IS
M
C
P
O
U
O
Expenses
∙ Expenses
∙ Cost of Sales
∙ Losses
X
X
X
N
IS
R
T
A
S
R
Y
DISCUSSION QUESTIONS
1. Discuss briefly the theory behind double entry-system.
2. State the rules of debit and credit.
3. Differentiate prepaid expenses from accrued expenses.
4. Give and discuss briefly at least three (3) examples of intangible assets.
5. Differentiate temporary withdrawals from permanent withdrawals. 6.
Identify and describe at least three (3) contra accounts.
7. Explain the accounting treatment of permanent and temporary accounts. 8. What
do you mean by natural business year? Is it similar to fiscal year? 9. Explain the
importance of preparation of financial statements for business entity. 10. Are the 5
major financial statements interdependent? Why?
MATRIX TRUE OR FALSE: In each item, select the letter that corresponds to the correct combination of two statements.
A. True, True B. True, False C. False, True D. False, False
1. ________ Statement 1: Gains are income that arises from the ordinary course of business activities.
Statement 2: Liabilities represent amounts owed to debtors.
2. ________ Statement 1: You own a business. Your business lacks capital so you provided additional cash. This
transaction would result to income by the business.
Statement 2: The settlement of liability requires the transfer of economic resource.
3. ________ Statement 1: Your business has total assets of P 10M, total liabilities of P 6M and total equity of P 4M.
This means that out of the total P 10M resources, you have provided P 6M.
Statement 2: The terms ‘economic resource’ and ‘present obligation’ refer to ‘income’ and
‘expense’, respectively.
4. ________ Statement 1: The difference between income and expense is profit or loss. There is profit if income
exceeds expenses.
Statement 2: The difference between the total debits and credits in an account represents the
balance of that account.
5. ________ Statement 1: Expense cause decreases in owner’s equity and are recorded by credits.
Statement 2: A debit entry always decreases the balance of an account.
6. ________ Statement 1: Normally, income accounts have debit balances.
Statement 2: For every transaction, there is at least one account affected.
7. ________ Statement 1: A basic storage unit for accounting data is the account.
Statement 2: Owner’s equity is the excess of an entity’s capital over its liabilities.
8. ________ Statement 1: Debit and credit can be interpreted to mean increase and decrease, respectively.
Statement 2: Note receivable is a contra asset account.
9. ________ Statement 1: An account has a debit of P 80 and a total credit of P 20. This account has a balance of P
60.
Statement 2: The balance of the account in the # 9 Statement 1 is referred to as a credit balance. 10. _______
Statement 1: Accounts payable and accounts receivable are opposites, meaning if I have an account payable to you,
you, in turn, have an account receivable to me.
Statement 2: If you want to increase the balance of a liability account, you will debit it.
STRAIGHT PROBLEMS
Problems 1
Elements of Financial Statements
Assets Liabilities Owner’s Equity
a. 767, 767 567, 765
b. 345, 543 327, 834
c. 638, 836 363, 836
d. 363, 836 132, 231
e. 260, 602 206, 602
Required: Fill in the amount of the missing element of financial position.
Problem 2
Income and Expenses
Income Expenses Profit/(Loss)
a. 163, 236 236, 163
b. 657, 576 (342, 243)
c. 809, 765 354, 435
d. 876, 203 (538, 978)
e. 937, 739 (164, 492)
Required: Supply the missing element of performance.
Problem 3
Instructions:
⮚ In Column A, indicate whether the account is Asset, Liabilities, Equity, Income or Expense.
⮚ In Column B, indicate the normal balance of the account.
ACCOUNTS
1. Prepaid Insurance
2. Supplies Expense
3. Accrued Expense
4. Gain on Sale of Equipment
COLUMN A
COLUMN B
5. Owner’s Drawings
6. Utilities Payable
7. Freight Out
8. Advances from Customers
9. Interest Receivable
10. Unearned Income
11. Inventory
12. Accumulated Depreciation
13. Allowance for Doubtful Accounts
14. Prepaid Expense
15. Land
16. Patent
17. Computer Equipment
18. Delivery Van
19. Tables and Chairs
20. Printer
21. Sales
22. Discount on Notes Payable
23. Cost of Goods Sold
24. Merchandise Inventory
25. Salaries Payable
26. Cash
27. Miscellaneous Income
28. Tuition Fees earned
29. Transportation Expense
30. Ex, Capital