Lesson VI.

THE ACCOUNTING EQUATION

A. Introduction

The Accounting Equation is Asset = Liabilities + Equity

1. That Assets are resources owned by the business.
2. That Liabilities are obligations by the business.
3. That Equity is the residual interest of the owner of the business. Meaning, any assets left after paying liabilities is the
right of the owner of the business.

There are four elements that affect equity:

1. Investment – refers to the initial and additional cash or other assets invested by the owner of the business.
2. Withdrawal – withdrawing of cash or other assets from the business for the owner’s personal use.
3. Revenue or Income - is the Increase in resources resulting from performance of service or selling of goods. Income
increases equity.
Examples of Income:
A. Service Business
1. Service Income 4. Tuition Fees
2. Rent Income 5. Consultation Income
3. Professional Income
B. Merchandising & Manufacturing Business
1. Sales
4. Expenses - is the decrease in resources resulting from the operations of business. Expenses decreases Equity in the
accounting equation.
Examples of Expenses
1. Salaries Expense 5. Interest Expense
2. Supplies Expense 6. Advertising Expense
3. Utilities Expense 7. Depreciation Expense
4. Insurance Expense 8. Rent Expense

4. That for every transaction, the accounting equation should always be balanced

Elements of Accounting Equation

A. Assets – are resources that an entity owns in order to derive future benefits. These are used by the company in its normal
operations such as manufacture of goods or delivery of services. The main feature of these assets is their capability to give
benefits to the entity. These benefits are usually in the form of their ability to directly or indirectly increase the flow of cash to
the entity or a reduction of its outflows.
Some examples of Assets.
1. Cash – it is the money that we use comprising the bills and the coins that we use in the everyday lives in order to
buy the goods that we want and also to avail the services that we need. However, when we do the accounting for
Cash, we also consider cash as the money that is deposited in the banks and even undeposited checks from
customers.
2. Accounts Receivables - are amounts due from customers arising from credit sales or credit services
3. Inventories are assets held for resale. Normally held for sale of the store in its normal operation
4. Equipment - are long-lived assets which have been acquired for use in operations like delivery trucks, cars.
5. Land and Building
6. Intangible Assets are assets without a physical substance. Examples include franchise and copyright.

B. Liabilities – claims of external parties from the entity. This are the debts and obligations of the company to another entity.
They are not always paid in cash but also can be paid on the form of performing services or even give something.
Some examples of Liabilities.
1. Accounts Payable are amounts due, or payable to, suppliers for goods purchased on account or for services
received on account.
2. Unearned Revenue or Unearned Income is cash collected in advance; the liability is the services to be performed
or goods to be delivered in the future

C. Equity – or Owner’s Equity is the residual interest of the owner from the business. It can be derived by deducting liabilities
from assets.
Equity comes from two (2) sources
1. Contributions of Owners in the form of investment of capital
2. Come from the income of the business from its normal operation
The Net Income or Net Loss is computed as:
Revenues – Expenses = Net Income / (Net Loss)
B. Using Accounting Equation

In using the Accounting Equation, one must remember that for every transaction, the accounting equation should always be
balanced, equality must always be maintained throughout all transactions because assets of the entity will always be claimed
by another party.

Accounting transactions always have a dual effect on the accounting equation. Each transaction of the entity would have to
effect at least two accounts in order for the equation to remain in balance. And that such account should be on the same side
(+Asset & -Asset) or on both sides of the equation (+Asset & +Equity) and (+Asset & +Liability).

Some examples to visualize the proper use of Accounting Equation

Illustration of the effects of the transaction in the accounting elements:

Assets invested by the owner
July 1 - Paolo Reyes started a delivery service on July 1, 2013. The following transactions occurred during the month of July. He
invested PHP800,000 cash and Cars amounting to PHP200,000
ASSETS = LIABILITIES + OWNER’S EQUITY
Cash Php800,000 Reyes, Capital Php1,000,000
Cars Php200,000

Borrowings from the bank

July 2 – Reyes borrowed PHP100,000 cash from PNB for use in his business.
ASSETS = LIABILITIES + OWNER’S EQUITY
Cash Php900,000 Loans Payable Php100,000 Reyes, Capital Php1,000,000
Cars Php200,000

Asset purchased for cash

July 7 – Bought tables and chairs from Orocan and paid PHP45,000 cash
ASSETS = LIABILITIES + OWNER’S EQUITY
Cash Php855,000 Loans Payable Php100,000 Reyes, Capital Php1,000,000
Cars Php200,000
Furnitures Php 45,000

Assets purchased on account

July 15 – Various equipment were purchased on account from Fortune for PHP55,000.
ASSETS = LIABILITIES + OWNER’S EQUITY
Cash Php855,000 Loans Payable Php100,000 Reyes, Capital Php1,000,000
Cars Php200,000 Accounts Payable Php 55,000
Furnitures Php 45,000
Equipment Php 55,000

Cash withdrawal by the owner

July 18 – Reyes made a cash withdrawal of PHP5,000 for personal use
ASSETS = LIABILITIES + OWNER’S EQUITY
Cash Php850,000 Loans Payable Php100,000 Reyes, Capital Php1,000,000
Cars Php200,000 Accounts Payable Php 55,000 Reyes, Drawing (Php 5,000)
Furnitures Php 45,000
Equipment Php 55,000

Payment of liability
July 20 – The account due to Fortune was paid in cash
ASSETS = LIABILITIES + OWNER’S EQUITY
Cash Php795,000 Loans Payable Php100,000 Reyes, Capital Php1,000,000
Cars Php200,000 Reyes, Drawing (Php 5,000)
Furnitures Php 45,000
Equipment Php 55,000
The following table summarizes the effects of these transactions on the accounting equation

Determining profit through operation

• Accrual basis of accounting vs Cash basis of accounting – accrual basis recognizes revenue when earned and recognizes
expenses when incurred
• Under the expense recognition principle, expenses can be recognized either as: (1) matching; (2) systematic allocation, or;
(3) direct association.
• Profit measures the performance of the company. If the revenue exceeds expenses, then it is a net profit; otherwise, it is a
net loss.

Received cash for revenue earned

July 21 – A customer hired the services of Reyes. Cash of PHP15,000 was received from the customers.
ASSETS = LIABILITIES + OWNER’S EQUITY
Cash Php 15,000 Service Revenue Php 15,000

Paid cash for expenses incurred

July 22 – Cash was paid for the following : gas and oil, PHP500 and car repairs, PHP1,000.
ASSETS = LIABILITIES + OWNER’S EQUITY
Cash Php 1,500 Gas and Oil (Php 500)
Car Repairs (Php 1,000)
Revenue rendered on account
July 24 – Another customer hired the services of Reyes and promised to pay PHP16,000 on July 31.
ASSETS = LIABILITIES + OWNER’S EQUITY
Accounts Receivable Php 16,000 Service Revenue Php 16,000

Paid for expenses incurred

July 25 – Paid PHP500 for telephone bill.
ASSETS = LIABILITIES + OWNER’S EQUITY

Cash (Php 500) Telephone Expense (Php 500)

Revenue earned with a down payment, balance on account

July 27 – Another customer hired the services of Reyes. A bill was issued to them for PHP20,000, 50% of which was collected
ASSETS = LIABILITIES + OWNER’S EQUITY

Cash Php 500 Service Revenue Php 20,000

Account Receivable Php 10,000

Customer’s account collected in cash

July 30 – The customer on July 24 paid 50% of his account in cash.
ASSETS = LIABILITIES + OWNER’S EQUITY

Cash Php 8,000

Accounts Receivable (Php 8,000)

Paid cash for expenses incurred

July 31 – Paid PHP10,000 for rental of office space, and salaries of PHP9,000
ASSETS = LIABILITIES + OWNER’S EQUITY

Cash (Php 19,000) Rent Expense (Php 10,000)

Salaries Expense (Php 9,000)
PRACTICE
For each transaction, tell whether the assets, liabilities and equity will increase (I), decrease (D) or is not affected (NE).

ENRICHMENT

Describe each transaction”

Answer Key:
1. The owner invested cash of PHP150,000 or the business earned PHP150,000 cash from providing services.
2. Purchased equipment at PHP20,000 for cash.
3. The owner withdrew cash of PHP112,500 or the business incurred PHP112,500 expenses and paid in cash.
4. The company purchased supplies on account.
5. The owner withdrew cash of PHP15,000 or the business incurred PHP15,000 expenses and paid in cash.
6. Paid liabilities worth PHP53,000.
7. The owner withdrew supplies worth PHP8,000 or the business used supplies worth PHP8,000.

Jerome Garcia started a new business and completed these transactions during August:

Aug. 1 Garcia invested PHP48,000 cash in the business.

1 Rented office space and paid PHP800 cash for the August rent.
3 Purchased exploration equipment for PHP22,000 by paying PHP12,000 cash and agreeing to pay the balance in 3 months.
5 Purchased office supplies by paying PHP1,500 cash.
6 Completed exploration work and immediately collected PHP420 cash for the work.
8 Purchased PHP1,350 of office equipment on credit.
15 Completed exploration work on credit in the amount of PHP8,000.
18 Purchased PHP700 of office supplies on credit.
20 Paid cash for the office equipment purchased on August 8.
24 Billed a client PHP2,400 for work completed; the balance is due in 30 days.
28 Received PHP5,000 cash for the work completed on August 15.
30 Paid the assistant’s salary of PHP1,100 cash for this month.
30 Paid PHP340 cash for this month’s utility bill.
30 Garcia withdrew PHP1,050 cash from the business for personal use.
Required
1. Arrange the following asset, liability, and equity titles in a table: Cash; Accounts Receivable; Office Supplies; Office
Equipment; Exploration Equipment; Accounts Payable; Jerome Garcia, Capital; Jerome Garcia, Withdrawals; Revenues; and
Expenses.
2. Use additions and subtractions to show the effects of each transaction on the accounts in the accounting equation. Show
new balances after each transaction.