BASIC ACCOUNTING AND REPORTING (Ballada, W., et.

al)
CHAPTER 3 – THE ACCOUNTING EQUATION AND THE DOUBLE ENTRY SYSTEM

THE ACCOUNT
The basic summary device of accounting is the account. A separate account is maintained for each
element that appears in the balance sheet (assets, liabilities and equity) and in the income statement
(income and expenses). Thus, an account may be defined as a detailed record of the increases, decreases
and balance of each element that appears in an entity’s financial statements. The simplest form of the
account is known as the “T” account because of its similarity to the letter “T”. The account has three parts:

ACCOUNT TITLE

Left Side or Right Side or

Debit Side Credit Side

THE ACCOUNTING EQUATION

Financial statements tell us how a business is performing. They are the final products of the accounting
process. But how do we arrive at the items and amounts that make up the financial statements? The most
basic toll of accounting is the accounting equation. The equation presents the resources controlled by the
enterprise, the present obligations of the enterprise and the residual interest in the assets. It states that
assets must always equal liabilities and owner’s equity. The basic accounting model is:

Assets = Liabilities and Owner’s Equity

Note that the assets are on the left side of the equation opposite the liabilities and owner’s equity. This
explains why increases and decreases in assets are recorded in the opposite manner (“mirror image”) as
liabilities and owner’s equity are recorded. The equation also explains why liabilities and owner’s equity
follow the same rules of debit and credit.

The logic of debiting and crediting is related to the accounting equation. Transactions may require
additions to both sides (left and right sides), subtraction from both sides (left and right sides), or an
addition and subtraction on the same side (left or right side), but in all cases the equality must be
maintained.

DEBITS AND CREDITS – DOUBLE-ENTRY SYSTEM

Accounting is based on a double-entry system which means that the dual effects of a business transaction
is recorded. A debit side entry must have a corresponding credit side entry. For every transaction, there
must be one or more accounts debited and one or more accounts credited. Each transaction affects at
least two accounts. The total debits for a transaction must always equal the total credits.

An account is debited when an amount is entered on the left side of the account and credited when an
amount is entered on the right side. The abbreviations for debit and credit are Dr. (from the Latin debere)
and Cr. (from the Latid credere), respectively.

The account type determines how increases or decreases in it are recorded. Increases in assets are
recorded as debits (on the left side of the account) while decreases in assets are recorded as credits (on
the right side). Conversely, increases in liabilities and owner’s equity are recorded by credits and decreases
are entered as debits.

The rules of debit and credit for income and expense accounts are based on the relationship of these
accounts to owner’s equity. Income increases owner’s equity and expense decrease owner’s equity.
Hence, increases in income are recorded as credits and decreases as debits. Increases in expenses are
recorded as debits and decreases as credits. These are the rules of debit and credit. 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 decreases in owner's equity Credit for increases in owner's equity

Expenses Income

Debit Credit Debit Credit

(+) (-) (-) (+)
Increases Decreases Decreases Increases

Normal Balance Normal Balance

NORMAL BALANCE OF AN ACCOUNT

The normal balance of any account refers to the side of the accounts – debit or credit – where increases
are recorded. Asset, owner’s withdrawal and expenses accounts normally have debit balances; liability,
owner’s equity and income accounts normally have credit balances. This result occurs because increases
in an account are usually greater than or equal to decreases.

Increases Recorded by Normal Balance

Account Category Debit Credit Debit Credit
Assets / /
Liabilities / /
Owner's Equity:
Owner's Capital / /
Withdrawals / /
Income / /
Expenses / /

ACCOUNTING EVENTS AND TRANSACTIONS

An accounting event is an economic occurrence that causes changes in an enterprise’s assets, liabilities,
and/or equity. Events may be internal actions, such as the use if equipment for the production of goods
or services. It can also be an external event, such as the purchase of raw materials from a supplier.

A transaction is a popular kind of event that involves the transfer of something of value between two
entities. Examples of transactions include acquiring assets from owner(s), borrowing funds from creditors,
and purchasing or selling goods and services.

TYPES AND EFFECTS OF TRANSACTIONS

It will be beneficial in the long-term to be able to understand a classification approach that emphasizes
the effects of accounting events rather than the recording procedures involved. This approach is quite
pioneering. Although business entities engage in numerous transactions, all transactions can be classified
into one of four types, namely:
 1. Source of Asset (SA). An asset account increases and a corresponding claims (liabilities or owner’s
equity) account increases. Examples: (1) Purchase of supplies on account; (2) Sold goods on cash
on delivery basis.
2. Exchange of Assets (AE). One asset account increases and another asset account decreases.
Example: Acquired equipment for cash.
3. Use of Asset (UA). An asset account decreases and a corresponding claims (liabilities or equity)
account decreases. Examples: (1) Settled accounts payable; (2) Paid salaries of employees.
4. Exchange of Claims (EC). One claims (liabilities and owner’s equity) account increases and another
claims (liabilities and owner’s equity) account decreases. Example: Received utilities bill but did
not pay.

Every accountable event has a dual but self-balancing effect on the accounting equation. Recognizing
these events will not in any manner affect the equality of the basic accounting model. The four types of
transactions above may be further expanded into nine types of effects as follows:
1. Increase in Assets = Increase in Liabilities (SA)
2. Increase in Assets = Increase in Owner’s Equity (SA)
3. Increase in one Asset = Decrease in another Asset (EA)
4. Decrease in Assets = Decrease in Liabilities (UA)
5. Decrease in Assets = Decrease in Owner’s Equity (UA)
6. Increase in Liabilities = Decrease in Owner’s Equity (EC)
7. Increase in Owner’s Equity = Decrease in Liabilities (EC)
8. Increase in one Liability = Decrease in another Liability (EC)
9. Increase in one Owner’s Equity = Decrease in another Owner’s Equity (EC)

TYPICAL ACCOUNT TITLE USED

STATEMENT OF FINANCIAL POSITION

Assets
Assets are should be classified only into two: current and non-current assets. Per revised Philippine
Accounting Standards (PAS) No. 1, an entity shall classify assets as current when:
a. The assets is cash or cash equivalent unless the asset is restricted to settle a liability for more than
twelve months after the reporting period.
b. The entity holds the asset primarily for the purpose of trading.
c. The entity expects to realize the asset within twelve months after the reporting period.
d. The entity expects to realize the asset or intends to sell or consume it within the entity’s normal
operating cycle.

All other assets should be classified as non-current assets. Operating cycle is the time between the
acquisition of assets for processing and their realization in cash or cash equivalents. When the entity’s
normal operating cycle is not clearly identifiable, it is assumed to be twelve months.

Current Assets
Cash. Cash is any medium of exchange that a bank will accept for deposit at face value. It included coins,
currency, checks, money orders, bank deposits and drafts.

Cash Equivalents. Per PAS No. 7, these are short-term, highly liquid investments that are readily
convertible to known amount of cash and which are subject to an insignificant risk of changes in value.

Notes Receivable. A note receivable is a written pledge that the customer will pay the business a fixed
amount of money on a certain date.

Accounts Receivable. These are claims against customers arising from sale of services or goods on credit.
This type of receivable offers less security than a promissory note.

Inventories. Per PAS No. 2, these are assets which are (a) held for sale in the ordinary course of business;
(b) in the process of production for such sale; or (c) in the form of materials or supplies to be consumed
in the production process or in the rendering of services.
Prepaid Expenses. These are expenses paid for by the business in advance. It is an asset because the
business avoids having to pay cash in the future for a specific expense. These include insurance and rent.
These prepaid items represent future economic benefits – assets – until the time these start to contribute
to the earning process; these, then, become expenses.

Non-current Assets
Property, Plant and Equipment. Per PAS No. 16, 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 and equipment, furniture and fixtures, motor vehicle and equipment.

Accumulated Depreciation. It is a contra account that contains the sum of the periodic depreciation
charges. The balance in this account is deducted from the cost of the related asset – equipment or
buildings – to obtain book value.

Intangible Assets. Per PAS No. 38, these are identifiable, nonmonetary assets without physical substance
held for use in the production or supply of goods or services, for rental to others, or for administrative
purposes. These include goodwill, patents, copyrights, licenses, franchises, trademarks, brand names,
secret processes, subscription lists and non-competition agreements.

Liabilities
Per revised Philippine Accounting Standards (PAS) No. 1, an entity shall classify a liability as current when:
a. The entity expects to settle the liability within the entity’s normal operating cycle.
b. The entity holds the liability primarily for the purpose of trading.
c. The liability is due to be settled within twelve months after the reporting period.
d. The entity does not have an unconditional right to defer settlement of the liability for at least
twelve months after the reporting period.

All other liabilities should be classified as non-current liabilities.

Current Liabilities
Accounts Payable. This account represents the reverse relationship of the accounts receivable. By
accepting the goods or services, the buyer agrees to pay for them in the near future.

Notes Payable. A note payable is like a note receivable but in a reverse sense. In the case of a note payable,
the business entity is the maker of the note; that is, the business entity is the party who promises to pay
the other party a specified amount of money on a specified future date.

Accrued Liabilities. Amounts owed to others for unpaid expenses. This account includes salaries payable,
utilities payable, interest payable and taxes payable.

Unearned Revenues. When the business entity receives payment before providing its customers with
goods or services, the amounts received are recorded in the unearned revenue account (liability method).
When the goods or services are provided to the customers, the unearned revenue is reduced and income
is recognized.

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 balance sheet date.

Non-current Liabilities
Mortgage Payable. This account records long-term debt of the business entity for which the business
entity had pledge certain assets as security to the creditor. In the event that the debt payments are not
made, the creditor can foreclose or cause the mortgaged asset to be sold to enable the entity to settle
the claim.

Bonds Payable. Business organizations often obtain substantial sums of money from lenders to finance
the acquisition of equipment and other needed assets. They obtain these funds by issuing bonds. The
bond is a contract between the issuer and the lender specifying the terms of repayment and the interest
to be charges.

Owner’s Equity
Capital (from the Latin capitalis, meaning “property”). This account is used to record the original and
additional investments of the owner of the business entity. It is increased by the amount of profit earned
during the year or is decreased by a loss. Cash or other assets that the owner may withdraw from the
business ultimately reduce it. This account title bears the name of the owner.

Withdrawals. When the owner of a business entity withdraws cash or other assets, such are recorded in
the drawing or withdrawal account rather than directly reducing the owner’s equity account.

Income Summary. It is a temporary account used at the end of the accounting period to close income and
expenses. This account shows the profit or loss for the period before closing to the capital account.

INCOME STATEMENT

Income
Service Income. Revenue earned by performing services for a customer or client; for example, accounting
services by a CPA firm, laundry services by a laundry shop.

Sales. Revenues earned as a result of sale of merchandise; for example, sale of building materials by a
construction supplies firm.

Expenses
Cost of Sales. The cost incurred to purchase or to produce the products sold to customers during the
period; also called cost of goods sold.

Salaries or Wages Expenses. Includes all payments as a result of an employer-employee relationship such
as salaries or wages, 13th month pay, cost of living allowances and other related benefits.

Telecommunications, Electricity, Fuel and Water Expenses. Expenses related to use of

telecommunications facilities, consumption of electricity, fuel and water.

Rent Expense. Expense for space, equipment or other asset rentals.

Supplies Expense. Expense of using supplies (e.g. office supplies) in the conduct of daily business.

Insurance Expense. Portion of premiums paid on insurance coverage (e.g. on motor vehicle, health life,
fire, typhoon or flood) which has expired.

Depreciation Expense. The portion of the cost of a tangible asset (e.g. buildings and equipment) allocated
or charged as expense during an accounting period.

Uncollectible Accounts Expense. The amount of receivables estimated to be doubtful of collection and
charged as expense during an accounting period.

Interest Expense. An expense related to use of borrowed funds.