BASIC ACCOUNTING

Analysis and Applications

Jonathan B. Navallo, CPA, MBA

Head, Department of Accounts and Business
Far Eastenr University - Nicanor Reyes Educational Foundation

Part-Time Faculty
College of Business, Entrepreneurship, and Accountancy
Miriam College
 Philippine Copyright, 2009
by

JONATHAN B. NAVALLO

Any copy of this book without the signature of

the author shall be considered as proceeding
from an illegal source.

ALL RIGHTS RESERVED

No part of this book may be reproduced in any

form or by any means, electronic or mechanical,
including photocopying, recording, mimeographing
or by any information retrieval system without the
permission of the author

JONATHAN B. NAVALLO
The Author
PREFACE
 CONTENTS
UNIT ONE: Understanding Basic Accounting Concepts
Chapter 1 Accounting as a Language of Business 1
Introduction; Accounting as a Service;
Chapter Exercises

Chapter 2 Reporting Business Operations

Chapter 3 The Accounting Equation: Uses and Sources of Funds

Chapter 4 Profit Determination: Capital Maintenance Approach

Chapter 5 Profit Determination: Transaction Approach

Chapter 6 Accounting Basis of Recording

UNIT TWO: Accounts and Financial Reports

Chapter 1 Assets 1

Chapter 2 Liabilities and Capital

Chapter 3 Income and Expenses

Chapter 4 Income Statement and Statement of Owner’s Equity

Chapter 5 Balance Sheet

Unit One
Understanding Basic Acounting Concepts

Contents

Chapter 1 Accounting as a Language of Business

Chapter 2 Reporting Business Operations

Chapter 3 The Accounting Equation: Uses and Sources of

Funds

Chapter 4 Profit Determination: Capital Maintenance

Approach

Chapter 5 Profit Determination: Transaction Approach

Chapter 6 Accounting Basis of Recording

Information is vital in all activities that require decision making. In business, whatever
task that requires an informed judgment require ample information in order to make
decisions that would be to the best interest of the company. Making a decision with-
out any facts or information, as basis, only equates to a simple guess and often lead to
wrong decisions.

Whatever managerial role one plays within an organization information is vital for the
proper discharge of one’s task. Information about a company is provided through ac-
counting reports. And to be able to use accounting reports, it is also important that
one should be able to understand how accountants present information pertaining to
the business. This module will briefly describe the definition of accounting and what
are the vital concepts behind the preparation of accounting reports. It is hoped that
the learner would have an appreciation and simple understanding about information
provided by accounting reports.
Chapter One:
Accounting as a Language of Business
Upon completing the lesson the student is expected to:

• Explain Accounting as a service activity

• Identify the information provided by Accounting
• Identify the different financial statements
• Identify the users of financial statements
• Explain Accounting as an art
• Identify the different Accounting processes

Introduction
Typically enterprising Filipinos are exemplified by what we see outside the malls and
business districts. We can make mention a cigarette vendor or a “sari-sari” store
owner we see in the daily conduct of our lives. Some of us would still be familiar of
the meat vendor or fish vendor when we go to a wet market. And even the sidewalk
vendors offering wares of countless varieties.

Conducting business activities preconceives the generation of profits. Basically, the

success of a day’s activities would be measured when one would find that he is a cer-
tain amount of pesos richer than he was at the start of the day. To a small entrepre-
neur, it is enough that he appropriates a certain amount of funds to replenish his
wares to be sold and appropriates the rest for his personal consumption. Simple as it
is, a typical enterprising Filipino requires to make only a handful of economic deci-
sions.

Could you think of what these economic decisions are?

What is the COMPANY GOAL?

Goal setting, in the planning process, is one of the vital func-
tions of a manager. The goal defines the direction the com-
pany will take in order for it to grow or survive.

1
 WHAT NOW? WHERE TO?

Ms. Chell Maniquiz is the owner of Du-Paint Company, a business engaged in

house painting. She is provided with accounting reports for last year’s opera-
tions and took note of certain aggregated items that she read from the reports.

Assets, Liabilities and Capital amounted P106,873, P28,940, and P77,933, re-
spectively. Income totaled P54,673, while expenses were P24,740.

What exactly are Assets? What are Liabilities? What do all these terms mean?

Accounting as a service activity

The Statement of Financial Accounting Standards define accounting as a service activ-
ity. Its function is to provide quantitative information, primarily financial in na-
ture, about economic entities that is intended to be useful in making economic
decisions in making reasoned choices among alternative courses of action.

Let us break down the definition into key points.

• Accounting is a service activity

• it provides quantitative information
• information useful in making economic decisions

It is a service activity where the accountant provides the user an overview of the
business condition.

Its output is primarily quantitative in nature as accounting reports, or financial state-

ments, are mostly presented in numerical terms. But there is nothing in the definition
that will exclude qualitative information that is difficult to express in quantitative or
financial terms. In fact, qualitative information if needed to be communicated to us-
ers are provided in the Notes to Financial Statements.

Elements comprising Financial Reports

The Elements of Financial reports are Assets, Liabilities, Capital, Revenues
and Expenses.

Assets refer to the total resources controlled by the company. Everything

that can provide the company future economic benefit.

Assets comprise what the company HAS.

Liabilities refer to the total obligations to other parties. These are consid-
ered as funds provided by creditors.

Liabilities comprise what the company OWES. Liabilities represent the

amount of funds provided by creditors to the entity.
 Capital refers to the residual or net interest of owners against the Assets of
the company after deducting Liabilities.

Capital comprise to what extent the company OWNS. It is also referred to as

Owner’s Equity or Equity Participation.

Or in simple terms, it is what is left after deducting what the company OWES
from what the company HAS, is equivalent to the funds provided by owners.

Primarily, the Capital account is affected by the owners’ Investment or With-

drawal. Investments occur when owners contribute money or property to the com-
pany. Withdrawals, or Drawings, occur when owners takes money or property from
the company. Furthermore, the Capital account may also be affect by Income and
Expenses.

Income are inflows of economic benefits that increase Capital, other than
investments made by owners.

Inflows of economic benefits may be accompanied by an INCREASE IN ASSET

or a DECREASE IN LIABILITY.

Expenses are outflows of economic benefits that decrease Capital, other

than withdrawals made by owners.

Outflows of economic benefits may be accompanied by a DECREASE IN AS-

SET or an INCREASE IN LIABILITY.

Information provided by Accounting

Accounting facilitates, users of financial statements, answers to various ques-
tions about the business like financial position, financial performance, changes in
capital, and fund sources and uses for purposes of decision making.

Financial Position shows the total Assets of company and the sources of
funds to acquire its assets that come from Liabilities (creditors) and Capital (owners).

Borrowed funds Liabilities

P20,000
Assets
P50,000

Invested funds Capital

P30,000

Figure 1.1. Financial position shows the amount of total assets is brought about by both the contrib-
uted funds of creditors and primarily the owners.
 Financial Performance shows the outcome of business operations that is
best shown by the business’ profit or loss. A Profit occurs when Income exceeds Ex-
penses. A Loss occurs when Expenses exceeds Income.

Income
P100,000
- Expenses
P60,000 = Profit
P40,000

Figure 1.2. Financial performance results from the difference between income and expenses. Ide-
ally, income should be more than expenses to gain profit.

Changes in Capital shows what factors increased or decreased the owner’s

investment.

Increase in equity may be due to profit or additional investment. Decrease in

equity may be due to loss or owner’s withdrawal.

Fund sources and uses show how cash were generated and used by the
business.

Different kinds of Financial Statements

The complete set of financial statements, or reports, to communicate the
business information will include the Balance Sheet, Income Statement, Statement of
Capital, Cash Flow Statement, and Notes to Financial Statements.

The Balance Sheet, or the Statement of Financial Position, provides the

financial position of the business. (See Figure 1.3)

The Income Statement, or Statement of Income and Expense, provides the

financial performance of the business. (see Figure 1.4)

The Statement of Capital provides the changes in owner’s equity or capital

of the business. (see Figure 1.5)

The Cash Flow Statement, or Statement of Cash Flows, provides the fund
sources and uses of the business.

The Notes to Financial Statements is an attachment to financial state-

ment that provides information that are not provided on the four financial statements
before mentioned. These include mandatory disclosures by existing standards,
schedules of important accounts, and other qualitative information that will help users
evaluate the information provided by financial statements.
 Du-Paint Company
Balance Sheet
January 31, 2006

ASSETS
Current Assets
Cash P 52,400.00
Accounts Receivable (Net) 12,800.00
Notes Receivable 4,500.00
Interest Receivable 23.00
Supplies on Hand 5,500.00
Prepaid Rent 2,000.00
77,223.00

Non-Current Assets
Furniture and Fixtures P 10,000.00
Office Equipment 20,000.00
30,000.00
Less: Accumulated Depreciation (350.00)
29,650.00

TOTAL ASSETS P 106,873.00

LIABILITIES AND CAPITAL

Current Liabilities
Accounts Payable P 15,500.00
Salaries Payable 150.00
Interest Payable 40.00
Utilities Payable 1,550.00
Unearned Painting Revenues 1,700.00
18,940.00

Non-current Liabilities
Loans Payable 10,000.00
10,000.00

Capital
Chell Maniquiz, Capital 77,933.00
77,933.00

TOTAL LIABILITIES AND CAPITAL P 106,873.00

Figure 1.3. The Balance Sheet provides the financial position of an entity. You can see the total
resources controlled by the entity and the amount owed to creditors and the interest
of the owner.
 Du-Paint Company
Income Statement
for the period ending January 31, 2006

REVENUES
Painting Revenues P 54,650.00
Interest Income 23.00
54,673.00

EXPENSES
Taxes and Licenses 2,500.00
Salary Expense 4,000.00
Utility Expense 1,550.00
Depreciation Expense 350.00
Doubtful Accounts 300.00
Supplies Expense 15,000.00
Interest Expense 40.00
Rent Expense 1,000.00
(24,740.00)

NET INCOME P 29,933.00

Figure 1.4. The Income Statement can be very helpful in determining the entity’s financial perform-
ance.

Du-Paint Company
Statement of Capital
for the period ending January 31, 2006

Chell Maniquiz, Capital - Beginning P -

Add: Initial Investment P 50,000.00
Net Income 29,933.00 79,933.00
79,933.00

Less: Chell Maniquiz, Withdrawal (2,000.00)

Chell Maniquiz, Capital - Ending 77,933.00

Figure 1.5. The Statement of Capital. The zero beginning capital balance signifies that the business
have just been started within the year.
Table 1.1. Schedule summarizing the different financial statements and the information each provides.

Financial Statement Information provided

Balance sheet Financial position
Income statement Financial performance
Statement of Capital Changes in Capital
Cash flow statement Fund uses and sources
Notes to financial statements Qualitative and detailed account reporting

Users of Financial Statements

Users of financial statements may either be external or internal.

External Users are those outside the business and make decisions concerning their
relationship with the business.
• Creditors
• Investors
• Financial analysts
• Government and its agencies

Internal Users are those inside the business and are directly affecting the opera-
tions of the business.
• Management
• Employees
• Board of directors, of a corporation

Accounting as an art
The American Institute of Certified Public Accountants defines accounting as
the art of recording, classifying, and summarizing in a significant manner and
in terms of money, transactions and events which are in part at least of a fi-
nancial character, and interpreting the results thereof.

• An art
• Recording
• Classifying
• Summarizing
• Interpreting

Accounting is an art because it requires an application of skill acquired

through experience and application of an informed judgment.
 Accounting is also a science since it follows a systematized body of
knowledge. In fact, one should first learn the science to be able to apply the
art.

The rest of the definition pertains to the process of journalizing, post-

ing, preparing financial statements, and analyzing of financial statements.

Bookkeeping encompasses the recording and classifying phase,

embodied in journalizing transactions up to the posting process.

It begins on the initial recognition of business transactions, analyzed

as to how they affect the elements of financial reports, in a sequential order
based on the date of occurrence, starting from the earliest transaction, the
most recent transaction being recorded last.

Summarizing encompasses the preparation of a list of the elements

of financial reports and the resulting balances as of the end of the period.
The information will be used to prepare financial statements.

The final task would be interpreting the financial condition and re-
sults of operations as shown in the financial statements by making an analysis
of account trends, relationships, and behaviors.

WHAT NOW? WHERE TO?

With an understanding of the elements of financial statement, Ms. Maniquiz is

able to acquire an understanding of the current business condition of Du-Paint
Company.

It is important that one needs to know where he will be starting. A direction

requires a point of origin in as much as a point of destination. The state of pro-
gress is always based on how one is able to influence a change in the com-
pany’s financial position and for how much. Having an objective of increasing
company resources would be futile if there are no figures to back the plan.

A business target starts with targeted revenues. Based on what is reported by

Du-Paint Company’s financial reports, revenues amount to P54,673.

First, it is expected that total revenues for the next reporting period should be
higher. If the same figure would be posted next year then this means that the
company was unable to improve its performance, being an unfavorable indica-
tion of stagnation. Much more if there is a decrease.

Second, a benchmark is provided to evaluate the result of operations for the

next period.
The current period’s figures shall be the basis of reference, as next years fig-
ures would be the basis of reference for the period after next year.

If Ms. Maniquiz would be targeting company sales to increase to P75,000, then

there is a clearer idea for a targeted revenue increase of P20,327. In this man-
ner, the plan could be properly assessed as to its feasibility. An action plan to
increase existing market share or penetrate new markets to increase revenues
will then be formulated to support the target.

On the other hand, Du-Paint’s expenses amounted P24,740. Whether this

would be seen as reasonable or excessive, would depend on an analysis of ex-
pense components. But it is without doubt that expenses should be reduced
when possible. An increase in expenses with no corresponding increase in
revenues is not good. Expenses when increasing should at least be proportion-
ate to the increase in revenues. It may be said that expenses for the next pe-
riod should be at most P35,000. This would in turn result to a targeted com-
pany income of P40,000 for next year. In this manner, Ms. Maniquiz has a
clearer idea of what direction the company would be going to and how she
would be evaluating results of her decisions, based on the degree of success
she was able to achieve closer to her target.
Chapter Two:
Reporting Business
Operations

Upon completing the lesson the student is expected to:

• Explain the concept of a Business

• Identify the economic activities involving business
• Identify and explain the types of business organizations
• Explain the Going concern principle
• Explain the concept of Relevance
• Identify and explain the important ingredients of Relevance
• Explain the concept of Accounting periods
• Distinguish the difference between a calendar and busi-
ness year
• Explain the concepts of Understandability, Reliability, and
Comparability

What does it mean to do BUSINESS?

Many have conceived a business idea but failed to start a
business. Many have embarked to engage in business and
failed. Ample finance is not an assurance of a successful
business venture but a passion for and understanding of the
trade.

A SIMPLE START

When Ms. Maniquiz conceived the idea of Du-Paint Company, she had her own
house painted by certain acquaintances who happened to be painters. A few
conversations afforded her to know the difficulty the painters are having in find-
ing customers with their limited friends. Aside from the fact that there are cer-
tain customers who happen to be reluctant to dole out any cash unless the job
is finished, thus, forcing them to borrow with interest that often discourages
them and lose the job to others.

Having the funds and list of potential customers, she made a proposal to hire
them. Which they willingly obliged, thus, the start of Du-Paint Company.
Business Defined

A Business may be defined as a collection of economic activities that gener-

ate profits. Business operations may involve economic activities as follows:
• Production
• Income distribution
• Exchange
• Consumption
• Saving
• Investment

Production is the process of converting economic resources into outputs of

goods and services that are intended to have greater utility than the required inputs
(e.g. WOOD + TOOLS + LABOR = FURNITURE).

Income Distribution is the process of allocating rights to the use of output

among individuals and groups in society (e.g. Payment of salaries).

Exchange is the process of trading resources or obligations for other re-

sources or obligations (e.g. Exchange of a car for money).

Consumption is the process of using the final output of the production proc-
ess (e.g. Placing raw materials, a product of a prior production process, to its own
production process).

Saving is the process by which individuals and groups set aside rights to pre-
sent consumption in exchange for rights to future consumption (e.g. Pablo earns
P200.00, spends P120.00 and keeps P80.00 as savings.).

Investment is the process of using current inputs to increase the stock of

resources available for future output as opposed to immediately consumable output
(e.g. A man starts a business or a man depositing money in a bank).

Production

Investment Consumption Income Distribution

Or Exchange

Saving

Figure 2.1. The cycle of economic activities involved in business.

As Simple as it Gets!
Shown are the economic activities that may be undertaken by Du-Paint Com-
pany during operations:

Category Description
Production Providing painting services to clients
Income Distribution Paying the salary of employees
Exchange Buying of painting supplies, entering
into contract with customers
Consumption Use of painting supplies
Saving Setting aside a portion of income
earned
Investment Placing money in a time deposit

Table 2.1. Schedule citing examples of economic activities.

Types of Business Organization

Companies vary on how they engage in various economic activities. They
could nevertheless be classified into three major types. The Types of Business Or-
ganizations are the Service Entity, Merchandising Entity, and Manufacturing Entity.

Service Entity involves businesses that provide services, being intangible

goods, to customers for a fee (e.g. schools, law firms, and accounting firms).

Merchandising Entity involves businesses that buy tangible goods and sell
them for a higher price. No further processing shall be made to the goods (e.g. gen-
eral stores and hardware stores). Subtypes of merchandising concern are wholesaling
and retailing

Manufacturing Entity involves businesses that buy tangible goods as raw

materials. These raw materials shall be combined with other materials, through the
application of labor, to produce goods of better value to be sold (e.g. processed meat
making, pot making, and furniture making).

How long will a business operate?

It may be observed that business operations involve a cyclical occurrence of

economic activities. The cycle is expected to go on indefinitely unless there is no
more reason for the business to engage on these economic activities. That is, if the
business will no longer be profitable because profit is the controlling motive of engag-
ing in business.
 But one of the uncertainties of engaging in business is the date of cessation,
to add up to the many risks that involve business.

It may be observed that business operations involve a cyclical occurrence of

economic activities. The cycle is expected to go on indefinitely unless there is no
more reason for the business to engage on these economic activities. That is, if the
business will no longer be profitable because profit is the controlling motive of engag-
ing in business. But one of the uncertainties of engaging in business is the date of
cessation, to add up to the many risks that involve business.

Definitely, ceasing to operate a profitable business is not an option and nei-

ther will it be a subject of a premeditated or intentionally sound business decision.
On the other hand, a business that consistently suffers losses will eventually be
ceased. So the question of until when is the business considered to operate will pre-
sents us to the Going Concern Principle.

The Going Concern Principle states that the business is assumed to oper-
ate indefinitely. This is also known as the Continuity Principle.

This does not allow the recording of its resources at market valuation or sell-
ing price. Thus, recognizing a gain if the market valuation or selling price would be
greater than the actual money paid for the resources. Gains, or losses, should only
be realized when resources are already sold. And this is contrary to a company’s in-
tention of using its resources for its operations.

Usefulness of Financial Statements

In this case, if the business is considered to operate indefinitely, when is the
best time to prepare reports? What factors contribute to the usefulness of reported
information? The questions that may be asked will lead to the time when should re-
ports be made and the characteristic of information that should be included in the
reports.

General accepted accounting principles consider Relevance as a principal

qualitative characteristic of financial reports. This is the quality of financial reports
that enables it to be capable of influencing a decision making process.
.
In order for information to be relevant, it should be provided within a period
when a decision could still be made and help users evaluate past, present, and future
events or confirming, or correcting, the users’ past evaluation.

Relevance is composed of three important ingredients – timeliness, predictive

value, and feedback value:

Timeliness is achieved when the information is provided within a period when

a decision could still be made. Otherwise, the usefulness of financial re-
ports is impaired.
 Predictive value is achieved when the information will help users evaluate
past, present, and future events, the evaluation of past and present
events being the foundation of evaluating future events.

Feedback value is achieved when the information will help in confirming, or

correcting, the users’ past evaluation.

When are Financial Statements prepared?

It is generally accepted that the reasonable period of preparing accounting
reports is one year, thus the concept of Accounting Periods.

Accounting Periods divides the life of the business into periods of one year
for reporting purposes only, there are no actual intervals of short cessation of busi-
ness operations. Anything lower than a year, is called an interim financial statement.
This facilitates timely reporting to users. The one year period may be a Calendar
Year or a Business Year.

A Calendar Year ends on 31st of December presumably starting on the 1st of

January.

A Business Year, or Fiscal Year, ends on any date other than the 31st of
December with a starting date that may vary. The starting date may be fixed at the
1st of July and ending date may be fixed at the 30th of June. A one year period for a
business year may be fixed at a 52 week interval, to mention one. Thus, a business
year starting at September 1, 2003, 52 weeks after including the first day, ends at
August 29,2004, with the next accounting period starting at August 30, 2004.

Reliability of Financial Statements

Relevance is a primary qualitative characteristic of financial statement. Nev-
ertheless, information should also be reliable to be useful to users of financial state-
ment. Timely information is of no use when such purport a fact that cannot be sub-
stantiated by evidence. Information should also be reliable, which brings us to an-
other primary qualitative characteristic of financial statements – Reliability.

Reliability is achieved when financial information is presented from sources

that can be relied upon by users, even if they are subjected to independent measures
using the same measurement techniques, and they are prepared in an unbiased man-
ner that there is an agreement between actual and depicted economic conditions or
events.

The ingredients of reliability are Neutrality, Faithful representation, Substance

over form, Conservatism or Prudence, Completeness.

Neutrality simply means that information, to be reliable, should be free from

bias or error.
 Faithful representation states that information must be a faithful repre-
sentation of the events or transactions it either purports to represent or could rea-
sonably by expected to represent.

Substance over form settles the issue when the economic substance of a
transaction contradicts its legal form, the economic substance of the transaction
should be followed.

Conservatism states that when there are two acceptable treatments, the
one less favorable to equity is chosen.

Completeness requires that adequate disclosure should be provided to help

users understand the information provided by financial statements.

Secondary Qualitative Characteristics

Primary qualitative characteristics deal with content of financial statements.
The last two other qualitative characteristics of financial statements deal with presen-
tation, thus, are treated as secondary to relevance and reliability. The last two quali-
tative characteristics are understandability and comparability.

Understandability is achieved when financial information provide data that can be

easily understood by users and is expressed in a manner and form adapted to the
users’ understanding.

Comparability is achieved when financial information present similarities and differ-

ences that enable users to note points of likeness and differences.
Chapter Three:
The Accounting Equation:
Uses and Sources of Funds

Upon completing the lesson the student

is expected to:

• Explain the concept of Assets

• Identify the major types of assets
• Explain the Cost principle
• Explain the concept of Capital
• Identify and explain the different
forms of business organizations

Equation One

ASSETS
(Uses of Funds) = CAPITAL
(Funds from OWNERS)

Figure 3.1. Initially, the entity’s assets come from the owner.

Initially, the owner shall invest funds to the business. The funds shall be
used to buy things or kept in case an urgent need for cash arises. Assets are re-
sources owned by the business, and may include the following:

• Money
• Products (in-process and for sale)
• Productive resources (used to create products)
• Claims to receive money
• Ownership interest in other enterprises

Money constitutes bills or coins, kept on hand or deposited in a bank, that

are kept for payment of obligations and expenses.
 Products are uses of funds to acquire commodities, bought or manufactures,
for sale in order to earn profit.

Productive resources are uses of funds to acquire property, machinery,

equipment, tools, and materials that are important in providing merchandise and ser-
vices.

Claims to receive money are uses of funds in instances when the one pos-
sessing funds lends to a borrower or when a provider of goods forgoes collection of
payment to motivate a customer to purchase, who cannot otherwise make a purchase
and immediately pay in cash.

Ownership interest in other enterprises are uses of funds that are in

excess of what is required to pay for immediate obligations or expenses, the intention
of which is to earn income that cannot otherwise be earned by simply safe keeping
the funds. Funds in other companies may be in a form of ownership interest in other
enterprises or a debt.

Basis of recording Assets

The Cost Principle governs the recording of assets, otherwise known as the
Historical Cost Principle. It states that all resources and services should be valued or
recorded based on the actual price paid. If the acquisition of an asset does not in-
volve the payment of money, an alternative valuation would be the value of the obli-
gation obtained and when undeterminable, the value of the non-cash asset given up
may be used.

Asset valuation under the cost principle can be restated based on the order of
priority, as follows:
• Actual money paid,
• Value of obligation obtained, and
• Value of the non-cash asset given up

What are sources of Funds?

The primary source of funds, coming from owners, is called Capital.

ASSETS = CAPITAL

Beginning balance P 0 = P 0

Owner invests P 10,000.00 cash 10,000.00 = 10,000.00

Total P 10,000.00 = P 10,000.00

 Funds from the owners increase business resources. The equality of the
aforementioned equation is to be maintained at all times.

Any additional investment from the owners will also increase both sides of the
equation. An investment is made when additional resources are provided by the
owner to the entity.

ASSETS = CAPITAL

Beginning balance P 10,000.00 = P 10,000.00

Owner invests P 5,000.00 cash 5,000.00 = 5,000.00

Total P 15,000.00 = P 15,000.00

A withdrawal made by the owner, on the other hand, will decrease both sides
of the equation. A withdrawal is made when the owner takes resources from the en-
tity.

ASSETS = CAPITAL

Beginning balance P 15,000.00 = P 15,000.00

Owner withdraws P 3,000.00 cash (3,000.00) = (3,000.00)

Total P 12,000.00 = P 12,000.00

Froms of Business Organization

Funds are important to enable the business to operate. Funds are used to
defray operating expenses and pay obligations arising out of business transaction.
However, owners are not confined to contribute just funds, or money, but also other
forms of resources that may benefit the business.

How owners will be making contributions of resources to the business may

depend on the forms of business organization established. The Forms of Business
Organization include the sole proprietorship, partnership, corporation, and gaining
attention are cooperatives.

On a Sole Proprietorship a single owner contributes resources to the com-

pany. The owner is called a proprietor. A proprietor is liable for all obligations ob-
tained by the company to the extent of his personal properties, otherwise known as
unlimited liability.
 For a Partnership, generally two or more individuals contribute re-
sources or industry to the partnership. Owners are called partners. Generally, part-
ners are liable for all obligations obtained by the company to the extent of their per-
sonal properties, otherwise they should declare themselves as limited partners.

For a Corporation, two or more individuals contribute resources by subscrib-

ing to shares of stock of the corporation. Owners are called stockholders or share-
holders. Stock certificates evidence ownership of shares. Stockholders or sharehold-
ers are liable for corporate obligation only up to their contributed resources to the
corporation, creditors cannot go after their personal properties, or having limited li-
ability.

For a Cooperative, two or more individuals contribute to the common fund

of the cooperative generally in a form of contributions. They are rather called mem-
bers not owners. The objective of a cooperative is to benefit its members even if for
a fact that it generates a considerable amount of profit. A credit cooperative provides
emergency funds or even startup capital for a small business. Farmers’ cooperative
provides lower cost for goods or services. There are various motives in establishing a
cooperative as long as it is established for the benefit of its members. Since there is
no particular owner, cooperative liability can only be satisfied up to the extent of co-
operative resources.

The Entity Concept

The Entity Concept governs the accountability of the business as a separate

entity from its owner or owners, otherwise known as the Economic Entity Assumption.
It states that the business should maintain a distinct and separate personality from
that of its owner or owners. Personal transactions of owners or his other businesses,
however it affects the business, should not be included as part of the operations of
the business. Furthermore, anything that may tend to violate the separate account-
ability of the business from its owner or owners should be avoided (e.g. maintaining
one bank account for the owners’ personal and business use).

Equation Two

ASSETS
(Uses of Funds)
= LIABILITIES
(Funds from CREDITORS)
+ CAPITAL
(Funds from OWNERS)

Figure 3.2. As the entity require more funds which could not be otherwise be provided by the owner, the entity
source funds from creditors to finance business operations.
 As the business requires more funds, to finance a project, and the owner can
no longer find personal sources of resources, he may borrow money from creditors
for use in the business. This will lead us to the Accounting Equation. The composi-
tion of assets characterizes how the funds available are used. The available funds
came from either the creditors or the owners. Liabilities are funds coming from the
creditors. Liabilities may be obligations to pay money or obligations to provide goods
or services. An increase in assets can mean an increase in either capital, as previ-
ously mentioned, or an increase in liabilities.

ASSETS = LIABILTIES + CAPITAL

Beginning balance P 12,000.00 = P 0 + P 12,000.00

Borrowed P 8,000.00 cash 8,000.00 = 8,000.00 + -

Total P 20,000.00 = P 8,000.00 + P 12,000.00

A decrease in assets can mean a decrease in capital or a decrease in liabili-

ties.

ASSETS = LIABILTIES + CAPITAL

Beginning balance P 20,000.00 = P 8,000.00 + P 12,000.00

Pays debt, P 10,000.00 (5,000.00) = (5,000.00) + -

Total P 15,000.00 = P 3,000.00 + P 12,000.00

It is important to point out that the Accounting Equation should always

be equal.
Chapter Four:
Profit Determination:
Capital Maintenance Approach

Upon completing the lesson the student is

expected to:

• Explain the concept of Profit

• Explain the concept of Loss
• Identify the two approaches in determining
business profit or loss
• Explain the concept of Net assets
• Determine profit or loss using the Capital
maintenance approach

Profit Defined
Business operates to generate profit. The best gauge of financial perform-
ance is through the determination of the its profit. A Profit is the net inflow of eco-
nomic benefits or resources that increase capital other than additional contributions of
owners. This will enable the business to pursue more profit-oriented activities to fur-
ther accumulate resources. On the other hand, A Loss is the net outflow of eco-
nomic benefits or resources that decrease capital other than distributions to owners.
There are two approaches in determining profit, the capital maintenance approach
and transaction approach. What will follow will deal with the capital maintenance
approach.
Capital Maintenance Approach : The Change in Net Assets
Business operates to generate profit. The best gauge of financial perform-
ance is through the determination of the its profit. A Profit is the net inflow of eco-
nomic benefits or resources that increase capital other than additional contributions of
owners. This will enable the business to pursue more profit-oriented activities to fur-
ther accumulate resources. On the other hand, A Loss is the net outflow of eco-
nomic benefits or resources that decrease capital other than distributions to owners.
There are two approaches in determining profit, the capital maintenance approach
and transaction approach. What will follow will deal with the capital maintenance
approach.

NET ASSETS = ASSETS - LIABILITIES

Figure 4.1. Net Assets, or capital, is the difference between total assets and total liabilities. Under the Capital
Maintenance Approach, income is gained when capital increases in an accounting period. On the
other hand, a loss incurred will decrease capital.

Under the Capital Maintenance Approach, profit is gained when there is

an increase in net assets. Otherwise, there is a loss. Net Assets is another term for
capital or owner’s equity. It represents the interest of owner’s over the assets of the
company, thus, the excess of assets over liabilities. Net assets represent the over-all
contributions of owners plus prior period earnings. It may be said that a business
intends to increase its net assets to accumulated economic benefits that will redound
to owners.

Determining Profit under the Capital Maintenance Approach

Problem 4.1

The following information is given about XYZ Company:

2003 2004 2005

Total assets P 1,000,000.00 P 1,100,000.00 P 1,200,000.00

Total liabilities 250,000.00 150,000.00 400,000.00

Net assets P 750,000.00 P 950,000.00 P 800,000.00

 2004 2005

Net assets, end of the year P 950,000.00 P 800,000.00

Net assets, start of the year 750,000.00 950,000.00

Operating profit/(loss) P 200,000.00 (P 150,000.00)

Notice that the business was able to increase its net assets in 2004 by
P200,000.00, the business gained operating profit or income. The business will be
able to use more resources and if possible distribute earnings to owners.

But in 2005, net assets decreased by P 150,000.00 reducing the amount of

resources that can be used by the business, the business incurred an operating loss.
It is evident that XYZ did well in 2004 and performed the opposite in 2005.

Not all increase in net assets involve a profit. When owners contribute addi-
tional resources this in effect will increase net assets but is in fact not equivalent to a
profit. Additional investment by owners should be deducted from the resulting in-
crease or decrease in net assets to get the actual profit or loss.

Not all decrease in net assets involve a loss. When owners withdraw a portion
of their investment this in effect will decrease net assets but is in fact not equivalent
to a loss. Withdrawals or distribution to owners should be added from the resulting
increase or decrease in net assets to get the profit or loss.

Problem 4.2

To illustrate further, let us assume that the owner made additional investments during
each year.

Additional information on XYZ Company, refer to Illustration 1:

2004 2005

Additional contributions by owners P 100,000.00 P 150,000.00

This will lead to a much different picture. Additional investments increase net
assets, which is also the nature of profit. Thus, we should deduct the amount
of additional investments made by the owner to determine the profit.
 2004 2005

Net assets, end of the year P 950,000.00 P 900,000.00

Net assets, start of the year 750,000.00 950,000.00

Change in net assets P 200,000.00 (P 150,000.00)

Additional contributions by owners ( 100,000.00) ( 150,000.00)

Operating profit/(loss) P 100,000.00 (P 300,000.00)

Problem 4.3

What if there are withdrawals? How will this affect net assets in determining profit?
Let us assume that the owner made withdrawals during each year.

Additional information on XYZ Company, refer to Illustration 1:

2004 2005

Withdrawal by owners 200,000.00 100,000.00

Withdrawals decrease net assets, which is also the effect of a loss. Thus, we should
add back the amount of withdrawals made by the owner to determine the profit.

2004 2005

Net assets, end of the year P 950,000.00 P 900,000.00

Net assets, start of the year 750,000.00 950,000.00

Change in net assets P 200,000.00 (P 150,000.00)

Withdrawal by owners 200,000.00 100,000.00

Operating profit/(loss) P 400,000.00 (P 50,000.00)

Therefore, a change in net assets or capital may involve one or all of the fol-
lowing:

• Increase in net assets due to additional contributions of owners

• Increase in net assets due to operating profit
• Decrease in net assets due to withdrawal by owners
• Decrease in net assets due to operating loss
Chapter Five:
Profit Determination:
Transaction Approach

Upon completing the lesson the student is expected to:

• Explain the concept of Revenues

• Identify revenues as distinguished from other increase
in net assets
• Explain the concept of Expenses
• Identify expenses as distinguished from other decrease
in net assets

Transaction Approach : Income less Expense

PROFIT = INCOME - EXPENSES

Figure 5.1. Profit is the excess of income over expenses. When expenses exceeds income, the result is called a
loss. This is the approach used in preparing the Income Statement.

Under the Transaction Approach profit or loss is determined by the result-

ing difference between revenues and expenses. A profit results when revenues ex-
ceed expenses. A loss results when expenses exceed revenues. In accounting, the
transaction approach is the approach used to determine profit. It is the format used
in preparing the income statement.
Income Defined

Income are gross inflows of economic benefits that increase net assets, or
capital, other than contributions from owners.

Key Points
• Gross inflows of economic benefits
• Increase net assets
• Not contributions from owners

Income are gross inflows of economic benefits that increase net assets other
than contributions from owners. This will exclude inflows of economic benefits that
do not increase net assets. Either the inflow tends to increase liabilities.

Illustration 5.1 Net Assets = Assets - Liabilities

Beginning 150 = 200 - 50

Example:
Borrowed money 0 = +10 - +10

No change in net assets 150 = 210 - 60

And there are inflows that decrease another type of asset.

Illustration 5.2 Net Assets = Assets - Liabilities

Beginning 150 = 200 - 50

Example:
Bought equipment 0 = +10(-10) - 0

No change in net assets 150 = 200 - 50

The simple reason is that if assets and liabilities would both increase for the
same amount, the resulting net assets will not be different from the resulting net as-
sets if they were not added at the first place. The same effect occurs if an increase in
asset is coupled by a decrease in another asset for the same amount.
Illustration 5.3 Net Assets = Assets - Liabilities

Beginning 150 = 200 - 50

Example:
Received money from = -
owner +10 +10 0

Increase in net assets 160 = 210 - 50

• Resources received from owners are gross inflows of economic benefits and they
pertain to contribution of owners. Their effect of increasing net assets is treated
as additional investments, and not as income.

• Resources received from customers, for goods or services provided, are gross
inflows of economic benefits and do not pertain to contribution of owners. Their
effect of increasing net assets is treated as income.

Note that to qualify as an increase to net assets, inflows of economic benefits

from customers should be in exchange for goods provided or services rendered by the
entity, not as a collection of a claim to receive money. Otherwise, there will be no
increase in net assets.

Illustration 5.4 Net Assets = Assets - Liabilities

Beginning 150 = 200 - 50

Example:
Debt to equity swap
(discussed in an ad- +10 = 0 - -10
vanced subject)

Increase in net assets 160 = 200 - 40

• Decrease in liabilities, with no outflow of resources, with a debt-to-capital conver-

sion, are also gross inflows of economic benefits since it extinguishes future out-
flow of resources. The liability is converted to increase contributions of owners.
Their effect of increasing net assets is treated as additional investments, and not
as income.

• Decrease in liabilities, with no outflow of resources, without a debt-to-capital con-

version, are also gross inflows of economic benefits since it extinguishes future
outflow of resources. The liability is not converted to increase contributions of
owners. Their effect of increasing net assets is treated as income.
Expense Defined

Expenses are gross outflows of economic benefits that decrease net assets,
or capital, other than distributions to owners.

Key Points
•Gross outflows of economic benefits
•Decrease owners’ equity
•Not distributions to owners

Expenses are gross outflows of economic benefits that decrease net assets
other than distributions to owners. This will exclude outflows of economic benefits
that do not decrease net assets. Either the outflow tends to decrease liabilities.

Illustration 5.5 Net Assets = Assets - Liabilities

Beginning 150 = 200 - 50

Example:
Paid a debt 0 = -10 - -10

No change in net assets 150 = 190 - 40

And there are outflows that increase another type of asset.

Illustration 5.6 Net Assets = Assets - Liabilities

Beginning 150 = 200 - 50

Example:
Bought equipment 0 = +10(-10) - 0

No change in net assets 150 = 200 - 50

Using a similar analogy, if assets and liabilities would both decrease for the
same amount, the resulting net assets will not be different from the resulting net as-
sets if they were not deducted at the first place. The same effect occurs if a decrease
in asset is coupled by an increase in another asset for the same amount.

Illustration 5.7 Net assets = Assets - Liabilities

Beginning 150 = 200 - 50

Example:
Bought equipment 0 = -10 - -10

No change in net assets 150 = 190 - 40

 • Resources given to owners are gross outflows of economic benefits and they per-
tain to distributions to owners. Their effect of decreasing net assets is treated as
withdrawals, and not as expenses.

• Resources given to suppliers, for goods or services received, are gross outflows of
economic benefits and do not pertain to distributions to owners. Their effect of
decreasing net assets is treated as expenses.

Note that to qualify as a decrease in net assets, outflows of economic bene-

fits to suppliers should be in exchange for goods or services received by the business,
not in payment of an obligation. Otherwise, they will not decrease net assets.

Illustration 5.8 Net assets = Assets - Liabilities

Beginning 150 = 200 - 50

Example:
Bought equipment -10 = - +10

No change in net assets 140 = 200 - 60

• Increase in liabilities, with no inflow of resources, as capital distribution, are also

gross outflows of economic benefits since it acknowledges future outflow of re-
sources. The liability is recognized for distribution to owners. Their effect of de-
creasing net assets is treated as withdrawals, and not as expenses.

• Increase in liabilities, with no inflow of resources, not as capital distribution, are

also gross outflows of economic benefits since it acknowledges future outflow of
resources. The liability is recognized not for distribution to owners. Their effect
of decreasing net assets is treated as expenses.

Determining Profit under the Transaction Approach

Problem 5.1

The following information is given about XYZ Company:

2004 2005

Income P 2,050,000.00 P 2,575,000.00

Additional investments 100,000.00 150,000.00

Expenses 1,950,000.00 2,875,000.00

 Profit and the change in net assets may be computed as follows:

2004 2005

Revenues P 2,050,000.00 P 2,575,000.00

Expenses (1,950,000.00) (2,875,000.00)

Operating profit/(loss) P 100,000.00 (P 300,000.00)

When owners contribute additional resources it increases net assets in addi-

tion to profit. Additional investment by owners should be added to the resulting profit
or loss to get the net increase or decrease in net assets.

When owners withdraw a portion of their investment it decreases net assets

in addition to loss. Withdrawals or distribution to owners should be deducted from the
resulting profit or loss to get the net increase or decrease in net assets.

Considering the above discussion, we will arrive at the computation below.

2004 2005

Revenues P 2,050,000.00 P 2,575,000.00

Expenses (1,950,000.00) (2,875,000.00)

Operating profit/(loss) P 100,000.00 (P 300,000.00)

Additional contributions by owners 100,000.00 150,000.00

Change in net assets P 200,000.00 (P 150,000.00)

Compare the above results with Problem 4.2 under the capital maintenance approach.
Chapter Six:
Accounting Basis of Recording

Upon completing the lesson the student is expected to:

• Explain a simple trading operation

• Explain the Cash basis of accounting
• Explain the Accrual basis of accounting
• Explain the Matching principle
• Explain the concept of Deferrals
• Explain the concepts of Prepaid expenses
• Explain the concept of Unearned revenues
• Explain the concept of Accruals
• Explain the concepts of Accrued expenses
• Explain the concept of Accrued revenues
• Determine profit and net assets applying the cash basis
• Determine profit and net assets applying the accrual basis

Supplier
Goods/Services Gives P 20.00

COMPANY Profits P 80.00

Goods/Services
Receives P 100.00
Customer

Figure 6.1. The Earning Process.

In buying, the company shall receive goods or services and at the same time
gives money as payment. In selling, the company receives money as collection and
provides goods or services. When the goods or services are received from the sup-
plier, the company incurs expenses. On the other hand, when goods or services are
provided to customers, the company earns revenues.

• Generally, revenues are earned when goods are delivered and services rendered
are complete.
• Generally, expenses are incurred when goods are received and services received
are complete.
 We will notice that in buying the company undertakes two separable activi-
ties, receiving of goods or services (or incurring expenses) and payment. We will also
notice that in selling the company also undertakes two separable activities, collection
and providing goods or services (or earning revenues). Since they are separable ac-
tivities one can occur simultaneously, before, or after the occurrence of the other.
Upon incurring expenses, payment may be made simultaneously, before, or after. In
the same way, upon earning revenues, the collection may occur simultaneously, be-
fore, or after.

The distinctions on when expenses are incurred and when payments are
made, as well as when revenues are earned and when collections are made, are im-
portant in determining the basis of recording used. There are two basis of accounting
for recording revenues and expenses and they are the Cash Basis and Accrual Basis.

Cash Basis of Accounting records revenues when money is collected and

records expenses when money is paid.
• revenues are recognized when collected
• expenses are recognized when paid

Accrual Basis of Accounting records revenues when earned and records

expenses when incurred.

• revenues are recognized when earned

• expenses are recognized when incurred

The Accrual Basis of accounting complies with the Matching Principle. The
Matching Principle states that revenue should be recognized along with the ex-
penses or cost incurred in generating the revenue, notwithstanding when the expense
is paid.

Paragraph 25-26, page 12, of the Statement of Financial Accounting Stan-

dards no. 1 (Revised 2000) states that “an enterprise should prepare its financial
statements…under the accrual basis of accounting”.

Note that if the expense is incurred and paid simultaneously, cash basis and
accrual basis will record equal expenses. On the other hand, when the revenue is
earned and collected simultaneously, cash basis and accrual basis will record equal
revenues.

Under the cash basis, only a single situation exist in recognizing revenues and
expense, the point of collection and the point of payment respectively.

This is different under the accrual basis, both revenues and expenses, may be
recognized and collected or paid for, deferred, or accrued. The first situation is obvi-
ous, revenues are both earned and collected and expenses are incurred and paid for.

Deferrals are delays in recognition because revenues are unearned and ex-
penses are prepaid. Unearned revenues are revenues already collected but not yet
earned. Prepaid expenses are expenses already paid but not yet incurred.
 During the accounting period, revenues may be collected even if not yet
earned. Nevertheless, the company should recognize an obligation to provide goods
or services to earn the revenue collected, increasing liabilities. During the same ac-
counting period, expenses may be paid even if not yet incurred. Nevertheless, the
company should recognize a claim to receive goods or services to incur the expense
paid, increasing assets. At the end of the accounting period, the unearned revenues
and prepaid expenses shall be adjusted to reflect the earned and incurred portions,
respectively.

Accruals are advance recognitions of revenues and expenses before collec-

tion or payment, respectively. These are only recognized at the end of the accounting
period. The two types of accruals are accrued revenues and accrued expenses. Ac-
crued revenues are revenues that are already earned and are yet to be collected.
Accrued expenses are expenses that are already incurred and are yet to be paid.
At the end of the accounting period, revenues are recorded although not yet col-
lected. Nevertheless, the company shall record a claim to receive money, until col-
lected, increasing assets. Also at the end of the accounting period, expenses are re-
corded although not yet paid. Nevertheless, the company shall record an obligation
to pay money, until paid, increasing liabilities.

Assets = Liabilities + Capital Profit = Revenues -Expenses

Accounts (Financial Position) (Financial Performance)

Unearned Revenues Assets (Increase; Money) None

Liability (Increase; Unearned)

Prepaid Expenses Asset (Increase; Prepaid) None

Asset (Decrease; Money)

Accrued Revenues Asset (Increase; Receivable) Revenue (Increase)

Accrued Expenses Liability (Increase; Payable) Expense (Increase)

Table 2.1. Schedule citing how deferrals and accruals affect the financial position and financial performance of an
entity.

Basis ofRecording: Accrual Basis versus Cash Basis

Problem 6.1

Mr. Bu Wang started Sure Fire Financial in 2004, a consumer credit company, with an
initial cash investment of P250,000.00. In January, he was able to lend out
P200,000.00. You checked his bank account and found the following:
 Collections Amount Payments Amount
Interest collection - January P 6,000.00 Rent for January to May P 5,000.00
Interest collection - February 4,000.00 Salaries of employees –
Interest collection - March 2,000.00 January 2,000.00

Total P12,000.00 Total P 7,000.00

At the end of January, Mr. Wang received billings aggregating P1,500.00 for
utilities consumed in January. And after checking the records, there are accrued in-
terests of P1,000.00, due for January. How would the two basis of recognition be
different in determining financial position and financial performance for January.

Financial Performance (Profit)

Cash Basis Accrual Basis
Revenues
Interest collection – January P 6,000.00 P 6,000.00
Interest collection – February 4,000.00
Interest collection – March 2,000.00
Accrued interest 1,000.00
Total revenues 12,000.00 7,000.00

Expenses
Rent for January to May 5,000.00 1,000.00
Salaries of employees – Jan 2,000.00 2,000.00
Billings received 1,500.00
Total expenses (7,000.00) (4,500.00)

Profit P 5,000.00 P 2,500.00

Computation of Net Assets
Cash Basis Accrual Basis
Assets
Money (250T-200T+12T-7T) P 55,000.00 P 55,000.00
Loan to borrowers 200,000.00 200,000.00
Prepaid rent (P 5,000.00 x 4/5) 4,000.00
Accrued interest 1,000.00
Total assets P 255,000.00 P 260,000.00

Liabilities
Accrued utilities (billing received) P 1,500.00
Unearned interest (Feb & Mar interest) 6,000.00
Total liabilities P 0.00 P (7,500.00)

Net assets P 255,000.00 P 252,500.00

Financial Position
Cash Basis Accrual Basis
Assets P 255,000.00 P 260,000.00
Total assets P 255,000.00 P 260,000.00

Liabilities P 7,500.00
Capital (or net assets) P 255,000.00 252,500.00
Total liabilities and capital P 255,000.00 P 260,000.00