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Module 5: Accounting Equation ·

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In this module, you will be able to ' . ••I

• explain the elements of accounting; . ..


• ~olve exercise~ on accou~ting principles:as applied' in various transactions; ··:~·;-'., · · · ·
• illustrate the accounting equation; and ; ' · · \L ,.
• perform ?perations in:volvingsimpl~ transa~tions using the'ac~ounting e·q~atio~.

In module 4, you learned that there are various accounting concepts and ·principles
that guide accountants in carrying out their tasks . In this module, you will understand
and appreciate how these concepts and principles are applied. But before that , you ,must
understand first how an accountant prepares financial statements. Do the foll<?wing
activity.

Below are the steps that an accountant performs in preparing financial-statemen!s,


Navigate the Web or interview an accountant and find out .how each step is don~.
1. Identifying transactions
2. Class.ifying transactions
3. Recording of transactions
4. Analyzing and interpreting transactions '.

The Accounting Equation


In accounting, it is understood that every business activity always has a two-sided effect
on the business. This two-sided effect is best illustrated in the accou~ting equ~ti~n., which
states that the asset of the business entity should always be equal to the business's total
capital added -to it~ total liabilitie 's to its suppliers. Thus , I ' ; l >.,.·,·
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Assets ·= Liabilities + Capital'
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.. Assei; , iiabilities, and capital . are the ihree key : •··.. .. Biijfi'}~;
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elements 'of accounting. Asset refers to the goods, .·£
. . ;• ·"'·','l; ' /
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:;1c1ea~ ::.:t}~I
services, and other resources that the business entity . '! .,,
· , .··Assets, liabilities,· and 1capital ·
acquired. Assets are the properties of the entity that ar~ th~_key ele,ment_s in a?c~u~ting.'
·
are expected to be utilized for its benefit. They may be ·The accounting equation m~intains·
tangible (such as cash, stocks, machiQe~y,equipment, the . oalance among these'. k~y
furniture, and land) or intangible (such as trademarks , elements. ,.. , ;
and patent rights). Liabilities are the entity's paY,abl~s L--- · ---- .
to its service, good, ~r resource provid~rs. C~pital refers to the amount of equity of the
------.1
business own~rs. Equity is the resulting amount when the total liabilities are subtracted
from the total. assets. Investments (initial and additional) and income (revenue and gains)
increase the .entity's capifal, .while withdrawals made by the owners as well as the entity's
expenses decrease it. · · 'j J'.
1 ·= J• ··,, .: • •

Capital and ·liabilities can be computed ·by rewriting 'the basic accounting equati.o'n as
1
follows: ·· 1

Capital = Assets - Liabilities


Liabilities = Assets - Capital

The relationship among these key elements of accounting is reflected on the balance
sheet or statement of financial position. t .• • , 1 :

I. What are the key elements of accounting? Define eac4.

2. How does the accounting equation help accountants?

.... ,....

Maintai_~ing the,Balari~e·
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1
The accounting equation is the. guidi~g- principie' 0 f -~ .' . ,. ::.·:. ( ·, ,):

· ·· an accountant · · · h
balance between assets and liabilities plu s capt't a 1 on the bala1 , • in ll!a1nt~1n11,1g
,. t .~
financial transactions of Mr. A who is st rt. h' nee sheet. Take a look at the
. ..: · a ..1ng ts Internet ff b · .
accountmg procedures are .done to prepar d t.h fi. - . ca e us1ness. Notice how the
. · · ~ e nancial stat .
transact10ns from 21 March to 6 April. · ements for Mr. A's business ·.

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21 ..
, .March I. . Own~r's initial 500 000.00 500 000.00
investm~nt. ' •• ~: f tI • • i ( I I

.... ~ ..

Mr. A's i!)itial inv~st~ent fo~s part of the entity's


. resources. Thus, , transaction I increases the·.business's
asset. Further, as mentioned earlier: investments increase I

the capital. Therefore, the amount of investment is entered


, under Capital. Since there are no payables yet, liabilities
r (
remam zero.

Transaction 2:
On 23 March, Mr. A purchased computer units at P200 000.00 ·on account, meaning it
is to be paid to the supplier upon delivery. But he made a do:wn payment of PSO 000.00 on
. ' .
that day.

21 March I. Owner's initial 500 000.00 500 000.00


I ; ' ti
investment

23 March 2. Purchased office 200 000.00 200 000.00


equipment ( computer
(50 000.00) (50 000.00) . •· l'•"I
units) on account

In transaction 2, Mr. A acquired computer units


for : his business operation. This purchase increases
his office equipment, which is part of his asset, by
.. All payables ·are · ·recorded (
P:200 000.00. But since he paid a down payment of :under liabilities. ,pnce i,ILa_b,i}ity, i~ !
PSO OOO.OO,
his cash (a~ asset) also decreases. You ·already ~a-id, t~e c~sh in the asset ;
will notice that on the balance sheet t_his ai:nount is dec~~as·e~ ~s·.~ell as the payables !
1)) ft' ;• ' f 1 • I ' ' ! . .:

recorded under As1set but is enclosed in pareiitheses 1( ). under liabilities. '


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In accounting, the parentheses . indi~ate . ~~du~~fon..

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The same
amount is recorded within parentheses
under L · b ·1· ·
· ta .I 1t1~s. .This means that the accounts payable
of P200 00 . · · !'
· 0.00 ~Iso. decreases by P-50 000.00 on the
same day. , .,, ·-~ - 'Pur~~asing-..o~ce ·equi~ment
._
has
~
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..... ~·- twb-fold effect ~:}ot{
1

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Transaction 3 : . , , ,, ... , 1,, ~usin~<s~ ~.rg_anizali~n'.s
_1~s.~~t~~ ;
i it increases · ,ts equipment" but ,t.
On 24 March, Mr. A paid Pl O 000.00 for the rent also 'decreases it~
--
9~:~:&
...
of the place that he will -occupy for the business. i; ·;.;;
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21 March 1. Owner's initial 500 000.00 .. 1· , .. 1 t.; ' · · , ' ·1 500 000.0Q
investment , 1 I '

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23 March 2. Purchased -office 200 000.00 200 000.00


equipment
(computer units) (50 000.00) (50 000.00)
on account r .)

f • • ~ I ) I ..i •

24 March 3. Payment of rent (10 000.00) (10 000.00)


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.. . . .- . .. . ·~1

In transaction 3, the cash (asset) decreases because _of an ex_p~ns~-for ~ent. Re~~ ~ be!
that expense decreases the capital; thus, there is a corresponding entry .under : C~pital ?n ,!hf
balance sheet. ·

' Transaction 4: 1'.

On 25 March, the computer units that were purchased on March . 23 were delivered.
: I
Mr. A paid the balance of P150 000.00. l

..Transaction .. ··
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21 March 1. Owner's initial 500 000.00 r t• ' } ,f , , 500 ,000.00


investment
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-23 March 2. Purchased ·office ~00 000.00 ,200 000.00 t t I • ~J •
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equipment
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(computer units) (50 000.0Q) (50 000.0Q).


on account . ; ' ' ;" .. . ,r

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24 March 3 · Payment of rent , ..


(IO 000.00) . ' '
'
.(10 000.00)
..
25 March 4. Payment of (150 000.00) (150 000.00)
balance from . ~
...

purchasing office ' '


I
equipment
.. ' - - ,. -

In transaction 4, the cash (asset) decreases because of the payment for the ·balance for
the purchase of the computer units. This also decreases the payables (liabilities) of the
business.

Transactions 5 and 6:
On 26 March, Mr. A paid Pl O000.00 to the computer technician who set up the network
connection for his business operation. ·On the same day, he also paid the Internet service
provider the amount of Pl 5 000 .00 for the Internet connection.

Transaction 7:
On 27 March, Mr. A purchased office supplies amounting to PS 450.00.
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Transactions 5 to 7 follow the same principle that has been discussed previously.
It is now time that you take over in maintaining the balance of records. Fill out t~e
balance sheet below for transactions 5, 6, and 7. ' ·

Date Transaction . As
~_,s(P) = Liabilities(P:) +. .capital (P:)-
26 March I
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27 March ..
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Transaction 8:
·.. . - ,· . _,; ·... .f P:300 ooo.oo 'as loan fro1n aiba~k . . . ~

· ·'t> h'i''Apn·1' M r. A rec ~}


1 e1ved an amount o ... ,...,:,· '
. ,

Liabilities (P) + Capi.tal.'~Pl'?. .


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., ·. Date· , •-· Trarisadion (' ('~ ssets (P').
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300 000.00 300 000.09


1 April 8. Loan from a
bank ,
.
. . . d h hich increases its asset.
Transaction 8 shows that Mr. A's busmess re~e1ve cas , w · ,
However, the cash received through the ban.k .loan also . increases .the .busiµ~ss's payable ~
(liabilities). ··

Transactions 9 toll:
·· On 2 April, .Mr. A's business becomes operational. Three days after he started
operations , he earned the following income: 2 April , P.15 000.00; 3 April, P'l 5 · 540.00;
4 April , 'Pl 7 675.00. ., .

Date Transaction Assets (P) = Liabilit ies (P') + Capital (P') ·. .:


. . 'I .

2 April 9. Cash revenue 15 000.00 15 000 .00


from operations

3 April 10. Cash revenue 15 540.00 15 540.00


from operations 'I I • f'

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4 April 11. Cash revenue 17 675.00 17 675.00
• I

from operations

Transactions 9 to 11 are income for the business and ·they increase its cash income
(asset). As mentioned earlier, income increases capital; thus, entries were also recorded
under Capital.

Transactions 12 and 13:


Aside fro1n computer rentals, Mr. A's Internet cafe also offers graphic design serVice.s . ·
On 5 April, he rendered graphic design services to some customers. The .services rendered ;'
which is 01i account (to be paid the following day), is worth PS 000.00. Further, on th~s '
day, his operations revenue is P16 750.00.

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...:, What Have I Learned So Far?

·.: :i-_!~~ased on :th e' accn1al c~ncepf of accounting (see ' mociule '4), an acc~untant' n~;~s ·~o··:,;,
record the income when-. t . .! d : . . ~ .. '. .
, .. . . . . 1 Is earne regardless of whether payment 1s already received !"
...Apply this accounting co·ncep t to transaction 12: In this . transaction, there fs 'an acco lirlt ;.,
receivable for Mr · A's b usmess · t h at must b e recor d e d a 1rea d y b ased on the accriia:1
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concept. ·. . .". :· 1 - , •• • •• ,
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. ~ecor9 _transactions 12·"and 13 ~hthe balan ce sheet'below.


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b-il-iti-
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5 April .
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Transactions 14 to 16:
·' .
On 6 April, Mr. A received the payment for the graphic design services he rendered
the previous day. For this day, his operations revenue is Pl 8 455.00 . But on the same
day, Mr. A made a withdrawal from his investment amounting to P20 000.00 for his
personal use.
"
. . Date , ,
.
.' ~ ,· ,/
. . .,,. ~,'- ~
;

6 April 14. Collection 5 000.00


of account • J .

receivable (5 000.00)

15. Cash revenue 18 455.00 18'455.00


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from .operations •I I.
·1

' ' (20 0~0:00)


16. Withdrawal (20 000.00)
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from investment ·!1 ! ; I .. I I •

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,H ~nows
··r:::,Tr-ahsiicliOn ;tM,t 11,i
e aC~ount receivlt\>J\: }II~ 'c\>ll~~i~ ~~aC~i~~:1~ ¥.t!~T
it~eidf ;The~~rore;' 'this 1~ireas es ·the cash and ·'decreases -the ·accounts receivable .-orthe
· These two accounts are both recorded under Asset . If you correctly answered the
busmess. . . ·
previous _acti~ity, you will find that the balance is still maintained by these rece~t entries.
Fm;ther, _the business operations for the day also increase the ass{?t(cash) and capital of the
busi~ess.
However, there is also a decrease in the business's Big
asset and capital due to the withdrawal from the ·Idea
investment by the owner. Recall the principle on capital
· Withdrawals by owners
mentioned previ_ously. Whil ~. i~come and i1:1vestme~ts l
from'the' in'vestments'
. decrease.
increase capital, withdra wals and expenses decrease
I • the business entity's asset and
t
it This is why on the balance sheet , transaction 16 capital.
l
d~creases the cash (asset) of the business as well as its
capital. i ·
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Recall the account ing equ ation : A ssets = Liabilities + Capital. On'.the balance she~t
·, I ' I

for transactions 1 to 16, you will notice the equal effect of each transaction on the assets
• .•~ -- ' - • _. ·• • I

and liab ilities plus capital. When done correctly , the ending balance for each transaction
would be equal.
If your answers to What Have I Lear ned So Fa r? are correct , you will have a total asset · ·
of _P827 970.00 , total liabilities of P300 000.00 , and total capital of P527 970.00.
. ..
Mr. A's Computer Cafe
Balance Sheet
For the per iod 21 March to 6 April
· (In Peso Amount ) ·
. . .. . .. ~
,. .

I
. Date
t

'
Transaction I
Assets = Liabilities +
.. .t ..•'. . :Capit~l,, .. ..
I
21 March 1. Owner 's initial 500 000.00 . 500 000.00
. investment ' I

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23 March 2. purchased office 200 000 .00
' . f
'
200 000.00 ;

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equipment i
-
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(50 000 .00) (50 000.00)
I
-. ·- - (~~mputer
.... . ....... units)
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on account
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124 March
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:

3. Payment of rent I (10 000.00 ) . ,


l(l O 000.00) '
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,if;
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\ '~·.:l~:rnient
~or:o~~arice
~.· _',·.·()50 .000 :00)
from purchasing ·· ·.. '
.-.. .' office equipment . •1 !. •• I I l · f:· t, • :!• :i I {

'
26 March
' 5. Payment for '
..
r

(10 000.00)
I I 11
··(l cf000.00)
.. , network connection l

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6. Payment for I (15 000.00) (, "
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.. , , (15 000.00)
Internet connection I , ' I

27 March 7. Purchased office . (5 4?0.00) . . : . (5, 450.00)


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supplies
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.
1 April 8. Loan fro in·a bank 300 000.00 300 000.00
( ~ ~ • r
i April 9. Cash revenue from 15 000.00 15 000.00
operations
I ' .'
3 April' 10. · Cash revenue from · 15 540.00 15 540.00
operations
. ·,:
''
4 April 11. Cash revenue from 17 675.00 • I 17 675.00
operations j I

5 April 12. Service revenue on 5 000 .00 I ,5 000 :90


account

13. Cash revenue from 16 750.00 16 750.00


operations
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6 April 14. Collection of 5 000.00


account receivable
• l
(5 000.00) ,! . ':

I •

15. Cash revenue from 18 455.00 18 455.00


,
operations
~ _ Ir . . !·

' ('' . .
16. Withdrawal of (20' 000.00) .. (20 000.00)
- . .. investi:nel!t .

82 7970.00 300 000.00 527 970.00

•• ,I - • • - • _ ..._ , ~ f It ;...._ • .~~

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... . BEYOND \VALLS 5.2 Appl~ It in Real Life

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You and your two friends have put up a small editorial se~1ce c?~pan~. : j
A~ .the.. only accountant in your group, you are assigned . t.o do the ac~ounti_rg j .?t
your company's financial transactions. Below is the re:cord of transact10ns 1n the f
' past weeks since .the company started its operation. Ensure the accuracy of the i
' · record of transactions by preparing a balance sheet using the accounting equation: !
, t t t
, Assets = Liabilities + Capital. .i

15 February Made an initial inveitment of P:200 000.00 ,'

16 February Purchased three coinputer .imits worth P:25 000~0,0 each · · ·~ · ·: · - ·


,, • ' . ' . • {' •\ I
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. 17 Fe~ruary · Paid rent worth Pl O 000.00 for the office unit to be used for the
. . . ... : .... (
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business -~ ,. ;-
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18 February Purchased three table and chair sets worth P3 000.00 each set . , .;
J , • , ~ • . ' • • , • ' I f

19 February . Rendered services to eight graduating student~ who _wanted ..their__ ;


research papers edited for P3 000.00 each ;.· , 1: t;.t. .•
1
1
. ' l
Purchased office supplies worth P5 000 .00 ·on account ' . .
I
;,,. ~ .~ .~ . i
.. ~·--
20 February Rendered services to a clientworth P:15 000.00 on account :
'
K;~:
r: ·
Payment of P'S 000.00 was paid by the client ·· ·
Paid the office supplies purchased on 19 February ,-·~-·; !
• > • ., ·>
I

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I .
21-23 February - Cash revenues from operations for these dates: P:12 000.00, I
........ _.._........ ,

P'll 350.00, P:16 000.00 , respectively . :··

24 February One of the owners · made a withdrawal from the investment ;


..amounting to P:25 000.00 for personal use · -
,. .
~ }:. "..
25-28 February Cash revenues from operations on these · dates: ~12 .500.00, ;
• - t t
P:13650.00, PJ5 .5..00.,0:0 , P:14350.00, respe ptiv (?iy ~ t. · ! ··
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1. What are the difficulties that you encountered in maintaining the balance among
assets, liabilities, and capital on the balanc~ sheet?

2. How can you apply the accounting equation in your everyday life experiences?
.-, .

Extend Your Knowledge


Learn more about the accounting equation and read further examples on the
balance between asset and liabilities plus capital in these Web sites:
• http ://www.myaccountingcourse.com/accounting-basics/accounting
-equation
• http ://www.investopedia.com/video/play I accounting-equation/
• http ://www.accountingcoach.com/ accounting-equation/ explanation
(All Web sites were last accessed on 20 July 2016.)
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ESSENTIAL LEARNING

In this module, you learned about the key elements of accounting-assets ,


liabilities, and capital. These key elements .need to remain balanced as accountants
prepare financial statements. Thus, the accounting equation, Assets = Liabilities +
Capital , is the principle used to maintain the balance.

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.'.
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Culminating Output

rr f I Track: Academic
I•• { •

You and your friends , who happened to be a group of accountants, decided to establish a..
small accounting firm. While you were looking for your first clients , you were able to survey·~
a few small businesses in your local community, namely, a newly opened -bookshop and an
eatery (carinderia), on.the kind of account_ing ser_vices their busines~es require. Your group.
was successful in convincing the business owners to avail of your services . As first task, the ·
managers of both businesses assigned you to help them in the accounting of their financial
transactions by preparing and presenting the cash flow and balance_shee~ fo-r the _last _four
months. You will present to them the financial statements through a PowerPoint presentation
and discuss the implications of the data for their businesses. Your output and performance
L

will be evaluated according to the accuracy and validity of data , your ability to answer ·
questions and clarify concerns, and the clarity and comprehensibility of your discussion .
I . .

Assessment Rubric

Accuracy and All data A few data are Most data


validity of data presented are inaccurate and presented are
,I
accurate and invalid. inaccurate and
valid. invalid .

Ability to answer All questions and A few questions Most questions


questions and concerns raised and concerns and concerns
clarify concerns by clients were raised by raised by clients
given appropriate clients were not were not answered
responses. answered or nor clarified.
1'
\ . clarified.
"
Clarity and All parts of . Some parts of Most parts of ,· ' . ,...
il I
II
II

comprehensibility . the discussion the discussion the discussion


of discussion were clear and were clear and were unclear and
comprehensible. comprehensible. incomprehensible.

Total

... ~·~{btAccountancy, Business, and Management 1


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I I. Write True on the blank if the statement is correct. If it is false, replace the underlined r I
I
word/phrase to make the statement correct. :. ..I
1. According to the Philippine Institute of Certified Public Accountants, 1
accounting is a system that measures business activities, processes I
I
given information into reports, and communicates findings to decision I
I
makers . I
I
I
____ 2. Only business activities that are of financial character are measured I
, I
in accounting. . I
! I
____ 3. The interconnected phases of bookkeeping include recording, I
I
classifying, summarizing, interpreting, and
. communicating
.
financial I
I
information. • I
I
I
____ 4. An accounting entity refers to an organization which makes use of I
resources to achieve its goals and objectives. I
I
I
_____ 5. A nonprofit business entity operates to generate income . .. . .. . I

____ 6. As an information system, accounting connects the transmitters


of information (accountants) and the set of receivers (users of
accounting information) using the financial statement as the medium
of communication .

--'-----
7. The statement of changes in equity provides information about a · I

business entity's financial and investment activities .

8. The statement of comprehensive income tells something ~about a


·business entity's financial condition or position in business.

, I
9. The statement of cash flows provides information about a bus~ness I
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