Accounting Principles 2

MODULE
1
Hello, dear student!
Welcome to this module MODULE CONTENTS
on Accounting Principles
2. This module will walk you
through the role of LESSON 1: The Role of
accounting in business. Accounting in Business
This module is specifically
LESSON 2: Financial
crafted to focus on the Statements and its
purpose of accounting Component
and the uses and
LESSON 3: Transaction
limitations of accounting Analysis and Double-
information in making entry System
business decisions.

Intended Learning
At the end of Module 1, you should be able to:

1. Recognize and discuss the role of accounting in business.

2. Identify the financial statements and its components and the
users.
3. Analyze transactions by using the accounting equation.
 Under the Conceptual Framework for
The Role of Accounting in
Financial Reporting, users of financial
Business
information or stakeholders may be
classified into two, namely:

What is Accounting? 1. Primary users –include existing and

potential investors, lender and other
creditors. They are the parties to whom
Accounting is a system for measuring and financial reports are primarily directed.
summarizing business activities, interpreting
financial information, and communicating 2. Other users – include employees,
the results to management and customers, government, and the
other stakeholders to help them make public.
better business decisions.

There are many definitions being given to Investors and Creditors

Accounting but the key points to be
considered are first, accounting is about Investors and creditors furnish a company
quantitative information, second, the with the money it needs to operate. If you
information being provided is financial in lent money to a friend to start a business,
character, and lastly, the information you’d want to know how it was doing.
should be useful in making economic Investors and creditors feel the same way.
decisions. They study financial statements to assess a
company’s performance and to help them
The Relevance of Accounting make decisions about continued
Information to the Users investment. They know that it’s impossible to
make smart investment and loan decisions
Accounting is often called “the language without an accurate report on an
of business” because it provides much of organization’s financial health.
the information that owners, managers,
and investors need to evaluate a
company’s financial performance. Other Users

Accounting can be divided into two major There are a host of other external users with
fields: an interest in a company’s financial
statements. For example, employees and
Management accounting provides labor unions are interested because salaries
information and analyses to decision and other forms of compensation are
makers inside the organization (such as dependent on an employer’s performance.
owners and managers) to help them
operate the business. The aforementioned stakeholders can also
be classified as internal or external users of
Financial accounting provides information financial information depending on how the
to people outside the organization (such interact with the business.
as investors, creditors, government
agencies, suppliers, employees, and labor
unions) as well as to internal managers to
assist them in assessing the financial
performance of the business.
EXERCISE 1.1
 FINANCIAL STATEMENTS AND ITS COMPONENT

Put yourself in the place of the woman in the figure below. She runs Connie’s
Confections out of her home. She loves what she does, and she feels that she’s doing
pretty well. In fact, she has an opportunity to take over a nearby store at very
reasonable rent, and she can expand by getting a modest bank loan and investing
some more of her own money. So it’s decision time for Connie: She knows that the
survival rate for start-ups isn’t very good, and before taking the next step, she’d like to
get a better idea of whether she’s actually doing well enough to justify the risk. As you
can see, she has several pertinent questions. We aren’t privy to Connie’s finances, but
we can tell her how basic financial statements will give her some answers.

Financial statements are a structure representation of the financial positions and

financial performance of an entity. Its objective is to provide information about the
financial position, financial performance and cash flows of an entity that is useful to a
wide range of users in making economic decisions.

Below are the components of the financial statement:

1. Income Statement
2. Statement of Changes in Equity (or Capital Statement)
3. Statement of Financial Position (or Balance Sheet)
4. Statement of Cash Flows (or Cash Flow Statement)
5. Notes to Financial Statements
 Income Statement

This is a report or formal statement showing the financial performance of an entity for a
given period of time. It shows whether the business is profitable or not. It describes the
income earned as well as the expenses incurred for a period.

Statement of Changes in Equity

This report shows the movement in the components of the equity or capital amounts
for a period of time. Net worth, equity or capital is affected by these three activities:
investment, withdrawal and net income or net loss. Investments and net income
increase equity while withdrawal and net loss decrease equity.

Statement of Cash Flows

This report provides information about the cash receipts (cash inflows) and cash
payments (cash outflows) of an entity during a period. It summarizes the operating,
investing and financing activities of an entity.

Balance Sheet

This report is a statement showing the three elements comprising the financial position
of the business, namely assets (resources controlled and owned by an entity such as
cash and non cash properties), liabilities (debts or obligations of an entity) and equity
(assets after deducting liabilities). It also shows the financial structure of the business –
out of the total assets owned by the firm, how much was financed by the owner and
by the creditors.

Notes to Financial Statements

This is used to report information that does not fit into the above reports in order to
enhance the understandability of the financial statements. It is also used to provide
narrative description, disaggregation and disclosures as required by the standard.
 Transaction Analysis and Double-
entry System

Let's discuss first the Golden Rules of Accounting. They are:

1. Debits ALWAYS EQUAL Credits
2. Debit what comes in and credit what goes out
3. Accounting equation: Assets = Owners Equity + Liabilities

Don’t let the words ‘debits’ and ‘credits’ scare you. They simply refer to the ‘left side’ and ‘right
side’ of a ‘T Account’, a graphical representation of the amounts recorded into an account
(see example below). Always remember that Debit means left and Credit means right.

The terms debit and credit signify actual accounting functions, both of which cause
increases and decreases in accounts, depending on the type of account. Here is a table
that will help you understand what this means and how it applies to:
 What is a liability?

Liabilities are present obligations

of the entity arising from past
The accounting equation is foundational to events, the settlement of which
accounting. It shows that the total assets of a is expected to result in an
business must always equal the total claims outflow from the entity of
against those assets by creditors and owners. resources embodying economic
The equation is expressed as: benefits.
ASSETS = LIABILITIES EQUITY
Liabilities
+
(economic (creditors’ (owners’ Current Non-current Liabilities
resources claims claims Liabilities
owned by on assets) on assets) Accounts Long-term loans and
an entity) Payable lease obligations, bonds
payable and deferred
What is an asset? revenue.
Assets are economic resources owned
by the entity and from which future
economic benefits are expected to flow
to the entity Assets can be classified into When financial transactions are recorded,
two, as follows: combined effects on assets, liabilities, and
equity are always exactly offsetting. This is
Assets the reason that the balance sheet always
balances.
Current assets Non-current assets
Each economic exchange is referred to as
Cash Land and buildings a financial transaction — for example,
Merchandise Equipment when an organization exchanges cash for
Inventory land and buildings. Incurring a liability in
Accounts Receivable Machinery return for an asset is also a financial
transaction. Instead of paying cash for
land and buildings, an organization may
What is owners equity? borrow money from a financial institution.
The company must repay this with cash
Equity represents the net assets owned by the
payments in the future. The accounting
owners (after deducting all its liabilities) . This is the
equation provides a system for processing
interest (equity) the owner has in the business.
and summarizing these sorts of
Below includes accounts that could increase or transactions.
decrease the owner’s equity.
Owners Equity If one item within the accounting
equation is changed, then another item
Drawings Capital contribution
must also be changed to balance it. In
Expenses/losses (decrease) Income/profit (increase) this way, the equality of the equation is
maintained. For example, if there is an
Salaries and Wages Sales
increase in an asset account, then there
Water and Electricity Interest Income
must be a decrease in another asset or a
Rent Expense Rent Income
corresponding increase in a liability or
Telephone Commission Received
equity account. This equality is the
Insurance Other income
essence of double-entry accounting.
Cost of Sales
Interest expense
Packing Material
Bank Charges
Advertising
Tax
Repairs & Maintenance
 The equation itself always remains in balance after each transaction. The
operation of double-entry accounting is illustrated in the following section, which
shows 10 transactions of Mcoy Works Corporation for January 2021.
Effect on the Accounting
Equation
Transaction
Number Date Description of Transaction
ASSETS = LIABILITIES + EQUITY
1 Jan.1 Mcoy Works Corp. issued
1,000 shares to Jericho
Rosales, the owner or
shareholder, for P500,000
cash. The asset Cash is
increased while the equity
item Share Capital is also
increased. The impact on the
equation is:

CASH +500,000
SHARE CAPITAL +500,000

Jan.2 Mcoy Works Corp. borrowed

2 P150,000 from the bank and
deposited the cash into the
business’s bank account. The
asset Cash is increased and
the liability Bank Loan is also
increased. The impact on the
equation is:
CASH +150,000
BANK LOAN +150,000

3 Jan.2 The corporation purchased

P200,000 of equipment for
cash.
There is an increase of the
asset Equipment and a
decrease to another asset,
Cash. The equation is:
EQUIPMENT +200,000
CASH -200,000

4 Jan.2 The corporation purchased a

tow truck for P400,000, paying
P150,000 cash and incurring
an additional bank loan for the
balance. The asset Cash is
decreased while the asset
Truck is increased and the
liability Bank Loan is also
increased. The impact on the
equation is:

TRUCK +400,000
CASH -150,000
BANK LOAN +250,000
 Effect on the Accounting
Equation
Transaction
Number Date Description of Transaction ASSETS = LIABILITIES + EQUITY

5 Jan.5 Mcoy Works Corp. paid P120,000

for a one-year insurance policy,
effective January 1. Here the
asset Prepaid Insurance is
increased and the asset Cash is
decreased. The impact on the
equation is:

PREPAID INSURANCE +120,000

CASH -120,000

Since the one-year period will not be fully used at

January 31 when financial statements are prepared,
the insurance cost is considered to be an asset at the
payment date. The transaction does not affect liabilities
or equity.
The corporation paid P100,000 cash to
the bank to reduce the loan
outstanding. The asset Cash is
6 Jan.10 decreased and there is a decrease
in the liability Bank Loan. The impact
on the equation is:

BANK LOAN -100,000

CASH -100,000

Jan.15 The corporation received P20,000 as

7
an advance payment from a
customer for services to be
performed in the future.

The asset Cash is increased by P20,000

and a liability, Unearned Revenue, is
also increased since the revenue has
not been earned as of January
15. It will be earned when the work is
performed in the future. At January 31,
these amounts are repayable to
customers if the work is not done (and
thus a liability). The impact on the
equation is:

CASH +20,000
UNEARNED REVENUE +20,000
 Effect on the Accounting
Equation
Transaction
Number Date Description of Transaction ASSETS = LIABILITIES + EQUITY

8 Jan.20 Automobile repairs of P50,000

were made for a customer;
P40,000 of repairs were paid in
cash and P10,000 of repairs will
be paid in the future. Cash and
Accounts Receivable assets of
the corporation increase. The
repairs are a revenue; revenue
causes an increase in net
income and an increase in net
income causes an increase in
equity. The impact on the
equation is:
CASH +40,000
ACCOUNTS RECEIVABLE +10,000
+50,000
REPAIR REVENUE
This activity increases assets and net
income.
The corporation paid operating
expenses for the month as follows:
9 Jan.31 The corporation paid operating
expenses: rent for P80,000; P175,000 for
salaries; and P20,000 for supplies
expense. The P35,000 for truck
operating expenses (e.g., oil, gas) was
on credit. There is a decrease in the
asset Cash. Expenses cause net income
to decrease and a decrease in net
income causes equity to decrease.
There is an increase in the liability
Accounts Payable. The impact on the
equation is:

RENT EXPENSE -80,000

SALARIES EXPENSE -175,000
SUPPLIES EXPENSE -20,000
TRUCK OPERATING EXPENSE -35,000
CASH -275,000
ACCOUNTS PAYABLE +35,000

Dividends of P10,000 were paid in cash

10 Jan.31
to the only shareholder, Jericho Rosales.
Dividends cause retained earnings
to decrease. A decrease in retained
earnings will decrease equity. The
impact on the equation is:

DIVIDENDS -10,000
CASH -10,000
 APPLICATION

Exercise 1.2
Copy the table into your answer sheet and indicate where each item on the list
below should go.
Assets Owners Equity Liabilities

1. Delivery vehicle
2. Money in the bank
3. Telephone bills
4. Interest on savings account
5. Photocopy expenses
6. Electricity bills
7. Sales of merchandise
8. Paid for repairs to the vehicle
9. Interest paid on the short-term loan
10. Cleaning material for the office
11. School fees of the owner’s son
12. Rent payable
13. Farming equipment
14. The office building
15. Petty cash fund
16. Money received for services rendered
17. Insurance premium paid to Sunlife
18. Advertisement in the newspaper
19. Meals for the office staff
20. Truck
Effect on the accounting equation
Each single transaction that takes place in a business has an effect on the accounting
equation. After each transaction the equation should still balance.

Example
The owner deposited P10, 000 in the bank to start his/her business.

Assets = Owners Equity + Liabilities

+ 10 000 + P10 000 0

So the business received a cash of P10,000 (cash is under assets) which serve as a
capital contribution of the owner (capital contribution is under Owner’s equity).

APPLICATION

Exercise 1.3

Use the table to indicate the effect of the transactions below on the accounting
equation. Put (+) sign if it increases and (-) sign if decreases.

Assets = Owners Equity + Liabilities

1. Telephone bills at P450.

2. Received P3,000 for fish and chips sold at the kiosk on the beach.
3. Electricity bill at P2,350.
4. Bought office supplies and paid by cash, P400.
5. Bought cleaning materials for the office using cash from petty cash fund, P220.
6. Paid wages of the workers for the day, P4,000.
7. Bought a new computer for the office and paid by cash, P8, 000.
8. Paid the owner’s TV by cash, P15,000.
9. Sale of merchandise on account.
10. Received P2,200 from the tenants renting the office.
 APPLICATION

Exercise 1.4

TRUE OR FALSE
Write T if the statement is true and F if false.

1. Accounting is an information and 12. An income statement reports on

measurement system that identifies investing and financing activities.
records, and communicates 13. The income statement displays revenues
relevant, reliable, and comparable earned and expenses incurred over a
information about an specified period of time due to earnings
organization's business activities activities.
2. An accounting information system 14. The statement of cash flows shows the
communicates data to help net effect of revenues and expenses for
businesses make better decisions. a reporting period.
3. Managerial accounting is the area 15. The income statement shows the
of accounting that provides financial position of a business on a
internal reports to assist the specific date.
decision making needs of internal 16. The first section of the income statement
users. reports cash flows from operating
4. The primary objective of financial activities.
accounting is to provide general 17. The balance sheet is based on the
purpose financial statements to accounting equation.
help external users analyze and 18. The purchase of supplies appears on the
interpret an organization's statement of cash flows as an investing
activities. activity because it involves the purchase
5. External users include lenders, of assets.
shareholders, customers and 19. The income statement reports on
regulators. operating activities at a point in time.
6. Regulators often have legal 20. The statement of cash flows identifies
authority over certain activities of cash flows separated into operating,
organizations investing, and financing activities over a
7. Internal users include lenders period of time.
shareholders, brokers and
managers.
8. The balance sheet shows a
company's net income or loss due
to earnings activities over a period
of time.
9. The three major types of business
activities are operating financing
and investing.
10. The three major types of business
activities are operating financing
and investing.
11. The four basic financial statements
include the balance sheet, income
statement, statement of owner's
equity, and statement of cash
flows.
End of Lesson 1