BASIC ELEMENTS OF ACCOUNTING

Based on the Framework of Accounting, the financial position or structure of a

business entity is based on three elements- assets, liabilities, and owner’s equity which
its financial performance is based on two elements called revenues and expenses.

ASSETS
- Are economic resources owned and controlled by the business.
- Used in operating the business and are expected to benefit the business over a
number of years
- Economic benefit is the ability of the asset to produce future cash flows for the
business entity whether directly (as when the asset is sold for cash) or indirectly
(as when it is used to create other assets such as machine used to produce goods
or services).
Three features:

 Resource obtained from a past event.

 The enterprise has control over it
 Future economic benefits will be received from its use
Assets Classification
Current assets
o cash and cash equivalents which are not restricted in use.
o other assets expected to be realized into cash or sold or consumed
within the normal operating cycle of the business or one year.
 o cash, short-term investments, receivables, merchandise inventory
and prepaid expenses.
Non-current assets
o assets do not include as current assets (long-term investments,
property, plant and equipment and intangibles)
o Property, plant and equipment (PPE) or fixed assets are assets not
intended for sale but are acquired since they are needed to operate
the business. PPE include land, building, equipment and furniture
and fixtures.

LIABILITIES
- Obligation to do or pay
- Present obligation arising from a past event, the settlement of which is expected to
result in an outflow of resources from the enterprise.
Three features:

 There is a present obligation

 Which arose from a past event
 Settlement is expected to be made in the future in the form of an outflow
of resources
- It is usually paid in cash but may also be paid in the form of property or service.
Liability Classification
Current liabilities
o those debts or obligations reasonably expected to be liquidated in
the normal course of the enterprise’s operating cycle
o paid within a period of one year by the use of current assets or the
creation of other current liabilities
o current liabilities: accounts payable, loans payable and utilities
payable.
Non-current liabilities
o Long term liabilities or obligations which are payable longer than one
year.
o notes payable, mortgage payable and bonds payable.
OWNER’S EQUITY
- the residual right or interest of the owner(s) in the entity’s net assets.
- Partners’ Equity and Shareholders’ Equity (Partnership and Corporation)
REVENUE
- An income represents inflow of cash or other assets coming from a client or
customer for service rendered or for merchandise sold.
- Revenue is income coming from the normal course of business
o (amounts received by an airline or bus company from passengers for
transportation services rendered or amounts received by a hospital
from patients for medical services rendered or amounts received by
a drugstore from customers for medicines sold)
- Gains is an income which may arise but not really from its normal course of
operation such as when machine no longer in use is sold at more than its
purchase cost.
EXPENSES
- The consumption of asset or using up of service to generate revenue.
- A business cannot earn revenue without consuming some assets or using up
services of other businesses or persons.
- Telephone Expense for service received from PLDT, Light Expense for service
received from Meralco, Salaries Expense for services received from employees.
Use of all forms of communication, electric power and water could be represented
by one account- Communication, Power and Water Expense or Utilities Expense.
CLASSIFICATION AS TO NATURE OF ACCOUNTS
REAL OR PERMANENT ACCOUNTS
- accounts in the statement of financial position
- it carry the as of balances of assets, liabilities and equity at any given point in time,
these are also called permanent accounts.
- We carry forward the balances of the assets, liabilities, and owner's equity to the
next accounting period unless the assets are disposed, the liabilities are paid and
the capital (representing claim over the remaining assets) is returned to the
owner.

NOMINAL
- income statement accounts
- these amounts represents the balance for a particular period only: for the month of
January 2020, for the six months ended June 30, 2020 or for the year ended
December 31, 2020 depending on the accounting cycle or reporting period of the
company
- At the end of accounting period, the balances of each accounts will be forwarded
to the owner’s equity accounts.
- Remember that income or loss goes to the owner of the business.
- Once the amounts are forwarded to the owner’s equity account, these accounts
will have zero balances in preparation for the start of next accounting period.

THE ACCOUNTING EQUATION

- basic tool of accounting, measuring the resources of the business and the claims
to those resources by its creditors and owners.
CONCEPT OF A BALANCED ACCOUNTING EQUATION
Asset = Liabilities + Equity
The reason is that the first assets or business resources are contributed by the owner of the
business. Secondarily, some assets will come from the creditors such as cash borrowed from
the bank and appliances, furniture, equipment, and goods purchased on account from the
suppliers. Assets are therefore claimable by two parties - creditors and owner(s).

Owner’s Equity= Asset- Liabilities

Liabilities= Asset-Equity
EXPANDED ACCOUNTING EQUATION

Primary motif of business is to earn profit.

The income statement (or profit or loss statement) shows how wealth or profit was
produced by listing the revenues earned against the expenses incurred
As illustrated, as the business starts its operation, the owner's equity will be affected
by four elements. The assets and liabilities will also change along the process to
maintain the balance of the equation.
Owner’s Capital
- represents the contribution or investment of the owner to the business thus
increasing the Owner’s Equity with corresponding increase in the assets.
Owner’s Withdrawals
- represents personal drawings of the owner from the business. It may be in the
form of cash or other assets such as supplies or inventories. Owner’s withdrawal
decreases the owner’s equity and assets of the business.
Revenues
- When revenue is recorded the assets will increase or the liabilities will decrease
with a corresponding increase in owner's equity
- The increase in assets due to revenue is claimable by the owner.
- The account titles used to describe revenue common to all servicers is Service
Income while Sales is the revenue title used by merchandisers and manufacturers.
- Specific account titles may be used to describe the service given such as Tuition
Income for a school, Medical Fees for a medical clinic, Accounting Fees for a CPA,
and Lease Income for a lessor.
 The Revenue Recognition or Realization Principle prescribes the recognition of
revenue as soon as service or merchandise has been delivered by the business
regardless of whether cash is collected or not. Assets will still increase but instead
of cash the account affected is accounts receivable.
Account Receivable represents a right to collect from patients, clients or
customers and is considered an asset because it is convertible into cash.
Expenses
- An expense will decrease an asset (if paid in cash) or increase a liability (if unpaid)
with a corresponding decrease in owner’s equity.
The Expense Recognition Principle requires that expense be recognized when
it occurs, that means service has been received, regardless of whether cash is
paid or not. If expense is unpaid, following the Accrual rule, a liability should be
recognized. The employee becomes a creditor of the firm, assets will remain the
same, and owner’s equity will decrease for the expense incurred. The accounting
equation will change as illustrated.
THE ACCOUNT---------------------------------------------------------------------------------------
- is a detailed record of all increases and decreases that have occurred in an asset,
liability, or equity during a specified period.

CONTRA ACCOUNTS
- offsets the balance in another, related account with which it is paired.
- Contra accounts appear in the financial statements directly below their paired
accounts.
- Sometimes the balances in the two accounts are merged for presentation
purposes, so that only a net amount is presented
- If the related account is an asset account, then a contra asset account is used to
offset it with a credit balance. If the related account is a liability account, then a
contra liability account is used to offset it with a debit balance. Thus, the normal
balance of a contra account is always the opposite of the account with which it is
paired.
Allowance for doubtful accounts and Accumulated Depreciation – two of the most
common contra-asset accounts.
ALLOWANCE FOR DOUBFUL ACCOUNTS
- The allowance represents management’s best estimate of the amount of accounts
receivable that will not be paid by customers.
- The allowance for doubtful accounts is a reduction of the total amount of accounts
receivable appearing on a company’s balance sheet, and is listed as a deduction
immediately below the accounts receivable line item.
ACCUMULATED DEPRECIATION
- Depreciation expense is a reduction in the value of fixed asset with the passage of
time, due in particular to usage and normal wear and tear
- The accumulated depreciation account appears on the balance sheet as a
reduction from the gross amount (purchase price) of fixed assets reported.
- Accumulated depreciation is the total depreciation for a fixed asset (building,
vehicle, furniture & fixtures, equipment, etc.) that has been charged to expense
since that asset was acquired and made available for use.
THE RULES OF DR AND CR
The T account
- simplest tool used to analyze the effects of the transactions on each account
- it has two sides: one side for recording increases and the other side for recording
decreases.
- Its shape comes from the letter T hence it is called a T account.
- The left part of the T account is called the debit side and the right part is called the
credit side. The title of the account is placed on top.
RULES OF DEBIT AND CREDIT
The rules of debit and credit lies on the basic accounting equation:
Assets= Liabilities + Owner’s Equity
Since the assets are on the left side or debit side, increases are therefore on the debit side and decreases
are on the credit side. Since liabilities and owner's equity are on the right side or credit side, increases
therefore are on the credit side and decreases are on debit side. Thus:
The normal balances of Drawings, Revenue and Expenses is based on its effect on the
owner’s equity accounts. Since revenue increases owner’s equity, its normal balance is
the same as the normal balance of equity which is on the credit side. Drawings and
Expenses decrease the equity; therefore its normal balance would be on the debit side.
An easy way to remember the rules of debits and credits is to memorize the
acronym: DC ADE-LER which stands for
Debit, Credit, Assets, Drawings, Expenses, Liabilities, Equity and Revenues. ADE all
have debit normal balances and LER have credit normal balances.
CHART OF ACCOUNTS
- a listing of account titles which guides the bookkeeper in the recording of the
transactions.
- The number and the nature of accounts depend on the type of business operation
and decided by the management. The accounts are properly arranged with the
assets listed first, followed by the liabilities and lastly by the owner's equity.
Account numbers are assigned for each account for easy reference.

DOUBLE ENTRY BOOKEEPING

The accounting equation forms the foundation of the double-entry accounting. It
requires that in all instances, the equality of the left and right side of the equation must
be maintained. That also means that in every transaction, the debit must be equal to
credit no matter how many accounts are affected.
This is called the Double Entry Bookkeeping System or Venetian Model which was
introduced by Luca Pacioli. The business transaction must always have a dual effect
and that is for every value received there is an equal value parted.
FINANCIAL TRANSACTIONS
- The accounting elements are affected by the business transactions or economic
activities of a business. A transaction is defined as an exchange of values between
two parties expressed in monetary terms. It has three characteristics: (1)
exchange of values, (2) between two parties, (3) in terms of money.
- The transaction must be stated in terms of money. Recall that this accounting
concept was mentioned in Module 1 and is called the Monetary Unit Principle. It
should also be noted at this point that transactions considered non- financial in
nature – no exchange of values, should not be recorded in the books of the
entity.
Examples of non-financial transactions:
- The travel agency hired tourist guides for a salary of P10,000 each.
- The travel agency signed a lease contract for the use of an office space at a
monthly rental of P18,000.
- An order for office supplies was placed with Good Trading amounting to P5,000.
To make these financial in nature:
- The travel agency paid cash for services rendered by the workers.
- The travel agency used the office space and paid the lessor.
- The travel agency received the supplies and paid cash.
In order to achieve the objectivity principle discussed in module 1, business
transactions are supported by business papers or source documents evidencing the
happening of the economic event. Some of the typical business papers (used by
practically all businesses) are the following:
Invoice. This is issued when service or merchandise is given to a customer or client.
Official receipt. This is issued when cash is received by the entity.
Cash or check voucher. This is a document used when cash is paid or a check is
issued.
Check. This is a negotiable instrument used as a substitute for cash, the payment for
which is drawn against the entity’s or individual’s current account.
Promissory note is a written promise to pay a certain sum of money at a future date.
Statement of account is a bill presented to a customer for service rendered or
merchandise given for which payment is demandable.