Chapter 3: Analyzing Business Transactions & Fundamental Accounting Equation 1

C H A P T E R 3
ANALYZING BUSINESS TRANSACTIONS&
FUNDAMENTAL ACCOUNTING EQUATION

Learning Objectives:

1. Know the transactions involved in operating a business and learn the different
accounting terms
2. Analyze the effects of business transactions on the firm’s assets, liabilities
and owner’s equity.
3. Analyze and record transactions in the accounts.
4. Understand the basic principles of double entry accounting
5. Value the importance of the fundamental accounting equation

The starting point in the accounting process is an analysis of the transactions of

a business. A business transaction is any financial event that changes the resources of
a firm. For example, purchases, sales, payments and receipts of cash are all business
transactions. The accountant must look at the effect of each business transactions to
decide what information to record and where to record it.

Thus, the study of accounting begins with an investigation into how the
accountant analyzes business transactions.

FOUR PHASES OF ACCOUNTING:

Based on the definitions (Chapter 1), accounting has the following phases
namely:

1. RECORDING
- technically called bookkeeping
- business transactions are recorded systematically and chronologically
in the proper accounting book.

2. CLASSIFYING
- items are sorted and grouped; similar items are classified under the
same name which can be classified as asset accounts, liability
accounts, capital accounts, revenue accounts and expense accounts.

3. SUMMARIZING
- after each accounting period, data recorded are summarized through
financial statements which are submitted to the management at the
end of each accounting period or as the need arises.

4. INTERPRETING
- due to the technicality of accounting reports, the accountant’s
interpretation on the financial statement is needed. In this case, analysis
reports are submitted together with the financial statements.

BUSINESS AS AN ACCOUNTING EQUITY

In accounting, the business is always assumed to be distinct and separate from

its owner or owners. This means that the personal properties of the owner are different
from the assets of the business, the liabilities of the business are different from his
personal obligations and the expenses incurred by the business are also different from
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his personal expenses. The transactions therefore, entered into by the owner in behalf
of the business should be recorded in the book of the firm.

Illustration: ACCOUNTING EQUITY

For example, Mr. V. Santos, who owns a store, manages his own
business and the monthly salary he is entitled to receive is Php
2,000. Since this amount of salary, the Mr. Santos should receive
at the end of each month is an expense of the business, it should
be recorded in the accounting books of the firm. This principle
holds true to all types of business, whether sole proprietorship,
partnership and corporation.

TRANSACTION

The data that is recorded in the accounting books are called transactions. These
are the economic activities of the firm. These activities could involve one enterprise
and another enterprise which is called external transaction or it may be activities within
the enterprise which is called internal transaction. Whenever a transaction occurred
there is an exchange of value for value. In every transaction, there is always a value
received and a value parted with, which may either be money, property or services.

Illustration: TRANSACTION:

Transactions Value Received Value Parted With

1. Purchased tools for cash Tools Money
2. Purchased office supplies on credit Office Supplies Obligation or Debt
3. Completed repair work for S. Andolong Cash Services
and received cash
4. Completed repair work for C. de Leon Receivable Services
on credit
5. Paid for advertising in the local paper Advertising Services Money
Cancellation of
6. Paid the account in #2 Obligation Money
Cancellation of
7. Received payment from C. de Leon Money Receivable
8. Paid the monthly salary of the assistant Services Money
Right to occupy the
9. Paid the rent of the shop space space Money
10. Paid the monthly telephone bill Services Money

ACCOUNTING ELEMENTS/VALUES
A. ASSETS
- economic resources owned by the business, include properties and
things of value in the name of the business.
1. CURRENT ASSETS
- assets which can be reasonably converted into cash within a short
period of time, usually within one accounting period or within the regular
operation of the business or normal operating cycle of the business
which is the period between the render of service, in case of service
concern, to the receipt of cash and the period between the acquisition
of materials to their conversion into cash.

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Illustration: REGULAR OPERATION OF THE BUSINESS

a. CASH/CASH ON HAND AND IN BANKS – includes currency of cash items on

hand, peso or foreign currency deposits in banks which are
unrestricted and immediately available for use in the current
operations of the business.
b. RECEIVABLES - represent the amount collectible from customers
arising from sales of merchandise, claims for money lent, or the
performance of service. This is usually presented as account
receivables in the balance sheet but if supported by a promissory
note, it is presented as note receivable.
c. INVENTORIES - constitute items of tangible personal property such as:
1. MERCHANDISE INVENTORY/FINISHED GOODS – held for sale in the
ordinary course of business
2. GOODS-IN-PROCESS/WORK-IN-PROCESS - items held which is still
in process for production (sub-assemblies)
3. RAW MATERIALS – items to be process or consumed in the
production of goods or services to be available for sale.
d. PREPAID EXPENSE – items which are already paid before they are used
or consumed.

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2. NON-CURRENT ASSETS
- assets not classified as current that could be tangible(property, plant
and equipment/machinery) or intangible (patent, certificate of stocks,
bonds, etc.)

B. LIABILITIES
- debts or obligations of the business to a party other than its owner.
1. CURRENT/SHORT-TERM LIABILITIES
– are those which are due for payment within a short period of time or
within one year from the balance sheet date.
a. ACCOUNT PAYABLE – indebtedness arising from purchase of goods and
services in the ordinary course of business.
b. NOTES PAYABLE – short-term indebtedness supported by written
promises to pay
c. ACCRUED EXPENSES – expenses already incurred but are not yet paid as
of the balance sheet date.
d. UNEARNED INCOME – arises when payments for undelivered goods or
services not yet rendered are received. This item is included among
current liabilities because it requires current asset for its liquidation,
say delivery of merchandise inventory

2. FIXED/LONG-TERM LIABILITIES
- are those which mature beyond one year from the balance sheet date
such as mortgage payable, bonds payable, and note payables due beyond
one year.

CHARTS OF ACCOUNTS
A chart of accounts is a list of account titles used by the business. It
serves as a guide to the bookkeeper in recording business transaction. Such
accounts are divided in sections and each title has a given code number.

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ASSET TITLES
CASH ON HAND – coins, currency and other cash equivalents owned by the
business and not yet deposited in the bank.

CASH ON BANK – unwithdrawn deposits in the bank. Usually the name of the
bank is used as account title.

NOTES RECEIVABLE – accounts collectible from customers for goods sold and
services rendered on credit or from others for loan granted. Such claims
are evidenced by a promissory note.

ACCOUNT RECEIVABLE – claims from customers arising fro goods sold or

services rendered on credit. It represents the debtors promise to pay.

ALLOWANCE FOR BAD DEBTS – a contra-asset account to provide for

uncollectible amounts. It is deducted from Account Receivable to present
the amount still collectible from debtors.

MERCHANDISE INVENTORY – goods purchased by the business to be sold at a

profit.

INTEREST RECEIVABLE – interest earned on notes on hand which has not been
received in cash.

SUPPLIES UNUSED - miscellaneous supplies which have been bought for office
use but are still unused as of the balance sheet date. Other account titles
which can be used are Supplies on Hand, Office Supplies, Store Supplies
and Factory Supplies.

PREPAID INSURANCE – insurance premiums paid in advance which are

applicable in the future periods.

FURNITURE & FIXTURES – includes tables, chairs, showcases, counters and

other similar assets owned and used by the business in its operation.

EQUIPMENT – includes typewriters, calculators, cash registers and other

similar assets.

DELIVERY EQUIPMENT – assets used for transporting merchandise.

ACCUMULATED DEPRECIATION – a valuation account that reduces the total cost

of the fixed asset. It is another contra-asset account that represents the
total amount of depreciation expenses charged in the past and current
periods.

LAND – land owned by the business used for building sites and other
business purposes

BUILDING – structure owned and used by the business in its operation.

LIABILITIES TITLES
NOTES PAYABLE – amounts due to the creditors which are supported by a
promissory note.

ACCOUNTS PAYABLE – amount due to creditors for goods or services bought

on credit.

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INTEREST PAYABLE – interest incurred but not yet paid.

SALARIES PAYABLE - amount due to the employees for services they have
rendered.

PROPRIETORSHIP TITLES
OWNER’S CAPITAL – amount of capital contributions of the owner or owners
to the business.

OWNER’S DRAWING OR OWNER’S PERSONAL – amount withdrawn by the owner

from the assets of the business for personal use.

INCOME TITLES
SALES – total sales of merchandise sold.

PROFESSIONAL FEE INCOME – amounts earned by professionals such as CPAs,

doctors, lawyers, etc. for services they render.

RENT INCOME – amounts of rental earned for the period

SERVICE INCOME – amounts of income earned from services rendered of a

service concern business

INTEREST INCOME – amounts earned for lending money

EXPENSE TITLES
COST OF SALES – cost of goods purchased and sold or materials
manufactured and sold.

ADVERTISING EXPENSE – expenses incurred to promote the product or

services of the business.

SALESMEN’S SALARIES – compensation given to sales agents.

SALESMEN’S COMMISSIONS – compensation given to sales agents based on the

amount of their sales.

SALESMEN’S TRAVELING EXPENSES – traveling allowance given to sales agents

OFFICE SALARIES – compensation of administrative employees

SUPPLIES EXPENSE – amount of supplies used

TAXES – duties incurred in the current period

UTILITIES EXPENSE – amount of light and water consumed by the business

REPAIR AND MAINTENANCE – Expenses incurred for repairing the assets of the
business

BAD DEBTS – estimated amount of losses from uncollectible accounts of the

business

DEPRECIATION EXPENSE – allocated cost of fixed assets in the current period.

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Asset, liability and proprietorship accounts are also called real accounts, balance sheet accounts
or permanent accounts. Income and expense accounts are sometimes called nominal accounts,
profit and loss accounts or temporary accounts.

IMPORTANCE OF ACCOUNTING EQUATION

Business transactions affect the assets, liabilities and proprietorship of

the business. These effects can be expressed in the accounting equation:
ASSETS = EQUITIES

Equity is the right, claim or interest of a person over the assets of the
business. Liability represents such claim in the assets of the business and
proprietorship is the owner’s or owners’ interest in the business.

LIABILITIES
EQUITIES
PROPRIETORSHIP

And since there are two sources of equities, one from the creditors
(liabilities) and the other from the owner (proprietorship), then the accounting
equation can be expressed as:

ASSETS = LIABILITES + PROPRIETORSHIP

The accounting equation is a tool for analyzing the effects of business

transactions on a firm’s assets, liabilities and owner’s equity.

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Illustration: ACCOUNTING EQUATION

TRANSACTION 1
Oct. 1 – Mr. Gil opened a motor repair shop and invested
Php100,000 cash.

Increase in Assets = Increase in Propietship

A = L + P
Cash Php Mr. Gil, Capital
100,000 = 0 + Php 100,000

Analysis:
The asset, cash is increased by Php 100,000.
The proprietorship account is also increased by Php 100,000.

TRANSACTION 2
Oct.3 – He purchased repair supplies worth Php25,000 on credit
from De Mesa Trading

Increase in
Assets = Increase in Liabilities
A = L + P
Repair
Supplies Due to De Mesa
Php25,000 = Trading Php25,00 + 0

Analysis:
The asset, repair supplies is increased by Php 25,000.
The account Due to De Mesa Trading is increased by Php 25,000

TRANSACTION 3
Oct. 5 – Billed M. Manzano for repair work done on his
automobile, Php 12,000

Increase in Assets = Increase in Propietship

A = L + P
Due from Mr.
Manzano Php Mr. Gil, Capital
12,000 = 0 + Php 12,000

Analysis:
The asset, due from Mr. Manzano is increased by Php 12,000
The proprietorship account is also increased by Php 12,000 due
to the revenue from service rendered.

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TRANSACTION 4
Oct. 7 – He bought a table and chairs for the business Php 6,000
cash.

Increase in one form of

Assets = Decrease in another form of Asset
A = L + P
Furniture Php 6,000
Cash (Php 6,000) = 0 + 0

Analysis:
One form of asset, furniture, is increased and form cash is
decreased.

TRANSACTION 5
Oct. 12 – Issued a promissory note to De Mesa Trading to apply
on his account (from Transaction 2)

Decrease in one
form of Liability = Increase in another form of Liability
A = L + P
Due to De Mesa Trading
(Php25,00)
Notes Payable
0 = Php 25,00 + 0

Analysis:
The account Due to De Mesa Trading is decreased and another
liability, note payable is increased.

TRANSACTION 6
Oct. 15 – Paid the salary of the assistant Php 1,900.

Decrease in Assets = Decrease in Propietship

A = L + P
Mr. Gil, Capital
Cash = 0 + (Php 1,900)

Analysis:
The asset, cash, is decreased by Php 1,900 and the
proprietorship account is also decreased due to the salary
expense incurred by the business.

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TRANSACTION 7
Oct. 20 – Paid the note issued to De Mesa Trading (Transaction
5).

Decrease in Assets = Decrease in Liabilities

A = L + P
Cash (Php Note Payable
25,000) = (Php 25,000) + 0

Analysis:
Both asset, cash and liability, note payable are decreased.

TRANSACTION 8
Oct. 29 – Mr. Gil withdrew Php 15,000 from the business for his
personal use

Decrease in Assets = Decrease in Proprietorship

A = L + P
Mr. Gil, Capital
Cash (Php15,00) = 0 + (Php 15,000)

Analysis:
The asset, cash, is decreased and the proprietorship is also
decreased due to the amount withdrawn by the owner for his personal
use.

As with the other mathematical equations, if any two parts of the equation
are known, the third part can easily be determined.

Illustration:

Assets = Liabilities + Proprietorship

? = Php 4,000 + Php 40,000
Php 44,000 = ? + Php 40,000
Php 44,000 = Php 4,000 + ?

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