1 Chapter 2 – The Accounting Equation

ACCOUNTING EQUATION is a mathematical expression used to describe the relationship between the assets,
liabilities and owners equity of the business model. The basic accounting equation states that assets equal
liabilities and owners equity, but can be modified by operations applied to both sides of the equation, e.g.,
assets minus liabilities equal owners’ equity.

𝐴𝑆𝑆𝐸𝑇𝑆 = 𝐿𝐼𝐴𝐵𝐼𝐿𝐼𝑇𝐼𝐸𝑆 + 𝑂𝑊𝑁𝐸𝑅 ′ 𝑆 𝐸𝑄𝑈𝐼𝑇𝑌

Assets are a company's resources—things the company owns. Examples of assets include cash, accounts
receivable, inventory, prepaid insurance, investments, land, buildings, equipment, and patents.

Liabilities are a company's obligations—amounts the company owes. Examples of liabilities include notes or
loans payable, accounts payable, salaries and wages payable, interest payable, and income taxes payable.

Owner's equity or stockholders' equity is the amount left over after liabilities are deducted from assets.

If a company keeps accurate records, the accounting equation will always be "in balance," meaning the left
side should always equal the right side. The balance is maintained because every business
transaction affects at least two of a company's accounts. For example, when a company borrows money
from a bank, the company's assets will increase and its liabilities will increase by the same amount. When a
company purchases inventory for cash, one asset will increase and one asset will decrease. Because there
are two or more accounts affected by every transaction, the accounting system is referred to as double-
entry accounting.

ANALYZING BUSINESS TRANSACTIONS

A business transaction is an economic event that has a direct impact on the business. A business transaction
almost always requires an exchange between the business and another outside entity. We must be able to
measure this exchange in terms of money (Philippine Peso).

All business transactions affect the accounting equation through specific accounts. An account is a separate
record used to summarize changes in each asset, liability, and owner’s equity of a business. Account titles
provide a description of the particular type of asset, liability, or owner’s equity affected by a transaction.

Three basic questions must be answered when analyzing the effects of a business transaction on the
accounting equation.

1. What happened?
• Make certain you understand the event that has taken place.
2. Which accounts are affected?
• Identify the accounts that are affected.
• Classify these accounts as assets, liabilities, or owner’s equity.
3. How is the accounting equation affected?
• Determine which accounts have increased or decreased.
• Make certain that the accounting equation remains in balance after the transaction has
been entered.

EFFECT OF TRANSACTIONS ON THE ACCOUNTING EQUATION

Each transaction affects at least two accounts and one or more of the three basic accounting elements. A
transaction increases or decreases specific asset, liability, or owner’s equity accounts.
2 Chapter 2 – The Accounting Equation

Sole Proprietorship Transaction #1.

Let's assume that J. Ott forms a sole proprietorship called Accounting Software Co. (ASC). On December 1,
2013, J. Ott invests personal funds in the form of a cash amounting to Php1,000,000 to start ASC. The effect
of this transaction on ASC's accounting equation is:

Assets = Liabilities + Owner’s Equity

Cash = + Ott, Capital
Dec. 1 + Php 1,000,000 = No effect + + Php 1,000,000

Analysis: This means that the business has an asset in cash amounting to Php1,000,000 and that J. Ott has a
right over this.

Sole Proprietorship Transaction #2.

On December 3, 2013 Accounting Software Co. spends Php35,000 of cash to purchase computer equipment
for use in the business. The effect of this transaction on the accounting equation is:

Assets = Liabilities + Owner’s Equity

Cash Equipment = + Ott, Capital
Dec. 1 Php 1,000,000 = + Php 1,000,000
3 -35,000 35,000
Bal Php965,000 35,000 = Php1,000,000

The accounting equation reflects that one asset increases and another asset decreases. Since the
amount of the increase is the same as the amount of the decrease, the accounting equation remains in
balance.

Sole Proprietorship Transaction #3.

On December 4, 2013 ASC obtains Php 300,000 by borrowing money from a bank. The effect of this
transaction on the accounting equation is:

Assets = Liabilities + Owner’s Equity

Cash Equipment = Loan Payable + Ott, Capital
Dec. 1 Php 1,000,000 = + Php 1,000,000
3 -35,000 35,000
Bal Php965,000 35,000 = Php1,000,000
4 +300,000 = +300,000
Bal Php 1,265,000 35,000 = 300,000 + 1,000,000

Analysis: ASC's assets increase and ASC's liabilities increase by Php 300,000.

EXPANDING THE ACCOUNTING EQUATION: REVENUES, EXPENSES AND WITHDRAWALS

Three key accounting elements of every business entity were defined and explained: assets,
liabilities, and owner’s equity. To complete the explanation of the accounting process, three additional
elements must be added to the discussion: revenues, expenses, and withdrawals.
3 Chapter 2 – The Accounting Equation

The EXPANDED ACCOUNTING EQUATION

𝐴𝑆𝑆𝐸𝑇𝑆 = 𝐿𝐼𝐴𝐵𝐼𝐿𝐼𝑇𝐼𝐸𝑆 + 𝑃𝐼𝐶 + 𝑅𝐸𝐵𝑒𝑔 + 𝑅 − 𝐸

FACTORS AFFECTING THE OWNER’S EQUITY ACCOUNT

The principal causes of its increases and decreases are the following:

1. Investment of the owner.

2. Additional investments of the owner.
3. Withdrawals of the owner.
4. Revenues
5. Expenses

REVENUES - SFAS No.1 define revenues as gross increases in assets or gross decreases in liabilities
recognized and measured in conformity with the GAAP that result from those type of profit-directed
activities of an enterprise that can change owner’s equity.

Kinds:

1. Service Revenues – revenues earned by performing services for a customer or client.

2. Sales Revenues – revenues earned as a result of sale of merchandise.

EXPENSES - SFAS No.1 defines expenses as gross decreases in assets or gross increases liabilities
recognized and measured in conformity with the GAAP that result from those types of profit-directed
activities of an enterprise that can change the owner’s equity.

WITHDRAWALS - Withdrawals, or drawing, reduce owner’s equity as a result of the owner taking
cash or other assets out of the business for personal use.

Sole Proprietorship Transaction #4.

On December 5, 2013 Accounting Software Co. pays Php 25,600 for ads that were run in recent days. The
effect of this advertising transaction on the accounting equation is:

Assets = Liabilities + Owner’s Equity

Cash Equipment = Loan Payable + Ott, Capital
Dec. 1 + Php 1,000,000 = + + Php 1,000,000
3 -35,000 35,000
Bal Php965,000 35,000 = Php1,000,000
4 +300,000 = +300,000
Bal Php 1,265,000 35,000 = 300,000 + 1,000,000
5 -25,600 = - 25,600
Bal 1,239,400 35,000 = 300,000 + 974,400

Analysis:

Since ASC is paying Php 25,600, its assets decrease. The second effect is a Php 25,600 decrease in owner's
equity, because the transaction involves an expense. (An expense is a cost that is used up or its future
economic value cannot be measured.)
4 Chapter 2 – The Accounting Equation

Sole Proprietorship Transaction #5.

On December 6, 2013 ASC performs consulting services for its clients. The clients are billed for the agreed
upon amount of Php 40,000. The amounts are due in 30 days. The effect on the accounting equation is:

Assets = Liabilities + Owner’s Equity

Cash Account Equipment = Loan + Ott, Capital
Receivable Payable
Dec. 1 + Php 1,000,000 = + + Php 1,000,000
3 -35,000 35,000
Bal Php965,000 35,000 = Php1,000,000
4 +300,000 = +300,000
Bal Php 35,000 = 300,000 + 1,000,000
1,265,000
5 -25,600 = - 25,600
Bal 1,239,400 35,000 = 300,000 + 974,400
6 +40,000 + 40,000
Bal 1,239,400 40,000 35,000 300,000 1,014,400

Analysis: Since ASC has performed the services, it has earned revenues and it has the right to receive Php
40,000 from the clients. This right (known as an account receivable) causes assets to increase. The earning
of revenues causes owner's equity to increase.

Sole Proprietorship Transaction #6.

On December 8, 2013, J. Ott withdraws Php100,000 of cash from the business for his personal use. The
effect of this transaction on ASC's accounting equation is:

Assets = Liabilities + Owner’s Equity

Cash Account Equipment = Loan + Ott, Capital Ott,
Receivable Payable Drawings
Dec. 1 + Php 1,000,000 = + + Php 1,000,000
3 -35,000 35,000
Bal Php965,000 35,000 = Php1,000,000
4 +300,000 = +300,000
Bal Php 1,265,000 35,000 = 300,000 + 1,000,000
5 -25,600 = - 25,600 -
Bal 1,239,400 35,000 = 300,000 + 974,400
6 +40,000 = + 40,000
Bal 1,239,400 40,000 35,000 = 300,000 + 1,014,400
-100,000 = -100,000
Bal 1,139,400 40,000 35,000 = 300,000 + 1,014,400 -100,000
Php 1,214,400 = Php 1,214,400

Analysis: The accounting equation remains in balance since ASC's assets have been reduced by Php 100,000
and so is the owner's equity under a new account title, Ott, drawings.
5 Chapter 2 – The Accounting Equation

Typical Accounts Titles Used

Assets – are commonly subdivided into two major classifications: current assets and non-current assets.

Current Assets - are generally those which can be expected to provide benefits to the business within the
normal operating cycle of the business or one year, whichever is longer.

- Cash. Any medium of exchange that a bank will accept at face value. It includes coins, currency,
checks, money orders, bank deposits and drafts.

- Cash Equivalent. These are short-term, highly liquid investments which are readily convertible to
cash and with original maturities of three months or less.

- Short-term Investments. Investments which are readily marketable and represent temporary
investments of funds available for current operations and are intended to meet with working capital
requirements.

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

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

- Inventory. Items of tangible personal property which are (a) held for sale in the ordinary course of
business, (b) in the process of production for such sale, or (c) to be currently consumed in the production of
goods and services to be available for sale.

- Prepaid Expenses. 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.

Non-current assets - are those which are used to provide the business entity with benefits over a number of
years.

- Long-term Investments. Assets not directly identified with the operating activities of the company or
involved in the sale or production of goods and services. Long-term investments are those usually acquired
for regular income, control, meeting business requirements, value appreciation and protection.

- Land. Owned and used by the business entity. No depreciation is recorded.

- Equipment. Records the acquisition and disposition of office machines, desks, cars, trucks, file
cabinets, and similar items. These assets have an estimated useful life beyond one year and are subject to
depreciation.

- Buildings. Included in this account are factories, warehouses, and office buildings. These are also
subject to depreciation over a number of years.

- Accumulated Depreciation. It is a contra account that contains the sum of the periodic depreciation
charges. The balance of this account is deducted from the cost of the related asset – equipment or building –
to obtain book value.
6 Chapter 2 – The Accounting Equation

- Intangibles. Long-lived assets without physical characteristics which value lies in rights, privileges
and competitive advantages, which they give the owner. These include patents, copyrights, licenses,
franchises, trademarks, etc.

Liabilities – They typically fall into two major groups: Current and long term liabilities.

Current Liabilities – are obligations which are reasonably expected to be settled through the use of existing
current assets or the creation of other current liabilities within the normal operating cycle or one year,
whichever is longer.

- Notes Payable. It is like a note receivable but in reverse sense. 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.

- 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.

- 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 and services, the amounts received are recorded in the unearned revenue account (liability method).
When the goods or services are provided to the customer, the unearned revenue is reduced and revenue is
recognized.

Long-term Liabilities – obligations which are payable beyond the operating cycle or one year, whichever is
longer, or those obligations which though payable within one year will not be liquidated by existing current
assets.

- Mortgage Payable. This account records long-term debt of the business entity for which the business
has pledged certain assets as security to the creditor.

- 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 charged.

Owner’s Equity

- Capital. 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 net income earned during the year or is decreased by a net
loss. 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
revenues and expenses. This account shows the net income or net loss for the period before closing to the
capital account.
7 Chapter 2 – The Accounting Equation

Financial Statements represent a formal record of the financial activities of an entity. These are written
reports that quantify the financial strength, performance and liquidity of a company. Financial Statements
reflect the financial effects of business transactions and events on the entity.

Four Types of Financial Statements

The four main types of financial statements are:

1. Statement of Financial Position

Statement of Financial Position, also known as the Balance Sheet, presents the financial position of an
entity at a given date. It is comprised of the following three elements:

Assets: Something a business owns or controls (e.g. cash, inventory, plant and machinery, etc)
Liabilities: Something a business owes to someone (e.g. creditors, bank loans, etc)
Equity: What the business owes to its owners. This represents the amount of capital that remains in
the business after its assets are used to pay off its outstanding liabilities. Equity therefore represents the
difference between the assets and liabilities.

2. Income Statement

Income Statement, also known as the Profit and Loss Statement, reports the company's financial
performance in terms of net profit or loss over a specified period. Income Statement is composed of the
following two elements:

Income: What the business has earned over a period (e.g. sales revenue, dividend income, etc)
Expense: The cost incurred by the business over a period (e.g. salaries and wages, depreciation,
rental charges, etc)

3. Statement of Changes in Equity

Statement of Changes in Equity, also known as the Statement of Retained Earnings or Capital Statement,
details the movement in owners' equity over a period. The movement in owners' equity is derived from the
following components:
a. Net Profit or loss during the period as reported in the income statement
b. Share capital issued or repaid during the period
c. Dividend payments
d. Gains or losses recognized directly in equity (e.g. revaluation surpluses)
e. Effects of a change in accounting policy or correction of accounting error

4. Cash Flow Statement

Presents the movement in cash and bank balances over a period. The movement in cash flows is classified
into the following segments:
Operating Activities: Represents the cash flow from primary activities of a business (Revenues and
expense).
Investing Activities: Represents cash flow from the purchase and sale of assets other than
inventories (e.g. purchase of a factory plant)
Financing Activities: Represents cash flow generated or spent on raising and repaying share capital
and debt together with the payments of interest and dividends.
8 Chapter 2 – The Accounting Equation

ILLUSTRATIVE EXAMPLE:

Joe Rosario is a painting contractor. He owned the JR Paints and Designs. During the month of
November, he completed the following transactions:

Nov. 3 Invested in the business painting equipment valued Php 24,700 and Php 150,000 cash.
4 Acquired a service vehicle costing Php 80,000. Paid Php 30,000 as downpayment and
signed a note for the balance
5 Purchased painting supplies on account for Php 4,300
6 Completed a painting job and billed the customer Php 4,800
7 Received Php 1,500 cash for painting an apartment room
10 Purchased painting supplies for Php 1,600 cash.
11 Received Php 4,800 from the customer billed November 6.
12 Billed a customer Php 6,200 for a painting job.
13 Paid his assistant Php 2,000 for a four day work.
14 paid Php 500 for the tune-up of the service vehicle
18 Paid for the painting supplies purchased Nov. 5.
20 Purchased a new ladder worth Php 5,000 and painting supplies Php 2,900, on account
21 Received Php 4,200 from the customer billed Nov. 12
24 Received Php 3,400 cash for painting a two-room apartment.
27 Paid Php 5,000 on the note signed for the service vehicle.
28 Paid the assistant Php 1,800 for a three and a half days of work.
30 Withdrew Php 5,000 from the business for personal use

JR Paints and Design

Financial Transaction Worksheet
November 30, 20XX

ASSETS = LIABILITIES + OWNER'S EQUITY

Rosario,
Date Cash A/R SV PS PE N/P A/P
Capital Explanation
3-Nov 150000 24700 174700
4-Nov -30000 80000 50000

5-Nov 4300 4300

Service
6-Nov 4800 4800 revenue
Service
7-Nov 1500 1500 revenue

10-Nov -1600 1600

11-Nov 4800 -4800
Service
12-Nov 6200 6200 revenue
13-Nov -2000 -2000 wage expense
maintenance
14-Nov -500 -500 expense
18-Nov -4300 -4300
9 Chapter 2 – The Accounting Equation

20-Nov 2900 5000 7900

21-Nov 4200 -4200
Service
24-Nov 3400 3400 revenue
27-Nov -5000 -5000
28-Nov -1800 -1800 wage expense
30-Nov -5000 -5000
BAL Php 113700 2000 80000 8800 29700 = 45000 7900 181300

234200 = 234200

*A/R – Accounts Receivable

*SV – Service Vehicle
*PS-Painting Supplies
*PE-Painting Equipment
*NP-Notes Payable
*A/P-Accounts Payable

JR Paints and Designs

Balance Sheet
November 30, 20XX

ASSETS LIABILITIES and OWNER'S EQUITY

Cash Php 113,700 Accounts Payable Php 7,900
Accounts Receivable 2,000 Notes Payable 45,000
Service Vehicle 80,000 Rosario, Capital 181,300
Painting Equipment 29,700 TOTAL Php 234,200
Painting Supplies 8, 800
TOTAL Php 234,200

JR Paints and Designs

Income Statement
for the month ended November 30, 20XX

Service Income Php 15900

Less: Operating Expenses
Wage Expense Php 3,800
Maintenance Expense 500 (4300)
Net Income Php 11600
10 Chapter 2 – The Accounting Equation

JR Paints and Designs

Capital Statement
for the month ended November 30, 20XX

Rosario Capital, November 3 Php 174,700

Add: Net Income 11,600
Less: Rosario Withdrawal (5,000)
Rosario Capital, November 30 Php 181,300

JR Paints and Designs

Cash Flow Statement
for the month ended November 30, 20XX

Cash Flows from Operating Activities

Cash Received from Customers Php 13900
Cash paid for expenses (4300)
Acquisition of Painting Supplies (5900)
Net Cash Provided by Operating Activities Php 3,700
Cash flows from Investing Activities
Acquisition of Service Vehicle (35000)
Net cash used in Investing activities (35,000)
Cash Flows from financing activities
Investment by Rosario 150000
Withdrawal by Rosario (5000)
Net Cash provided by Financing Activities 145,000
Net Increase (Decrease) in Cash Php 113,700
Cash Balance at the beginning of the period -
Cash Balance at the end of the period Php 113, 700
11 Chapter 2 – The Accounting Equation

Name: Score:
Year and Section: Date:

Damon Young has started his own business, Home and Away Inspections. He inspects property for buyers
and sellers of real estate. Young rents office space and has a part-time assistant to answer the phone and help with
inspections. The transactions for the month of September are as follows:

(a) On the first day of the month, Young invested cash by making a deposit in a bank account for the
business, P 1,500,000.
(b) Paid rent for September, P 10,000.
(c) Bought a used truck for cash, P204,000.
(d) Purchased tools on account from Crafty Tools, P 139,000.
(e) Paid electricity bill, P2,000.
(f) Paid two-year premium for liability insurance on truck, P20,000.
(g) Received cash from clients for services performed, P52,000.
(h) Paid part-time assistant (wages) for first half of month, P8,000.
(i) Performed inspection services for clients on account, P40,000.
(j) Paid telephone bill, P1,535.
(k) Bought office supplies costing P4,300. Paid P1,800 cash and will pay the balance
next month, P2,500.
(l) Received cash from clients for inspections performed on account in (i), P40,000.
(m) Paid part-time assistant (wages) for last half of month, P8,000.
(n) Made partial payment on tools bought in (d), P100,000.
(o) Earned additional revenues amounting to P67,400: P43,400 in cash and balance on account.
(p) Young withdrew cash at the end of the month for personal expenses, P 50,000.

REQUIRED
1. Enter the transactions in an accounting equation similar to the one illustrated below:
2. Compute the ending balances for all accounts.
3. Prepare a Balance sheet as of September 30, 20XX.

Assets = Liabilities + Owner’s Equity

Date Cash Account Supplies Prepaid Tools Truck = Account + Young, Young, Revenues Expenses Description
Receivable Insurance Payable Capital Drawing
(a) =
(b) =
(c) =
(d) =
(e) =
(f) =
(g) =
(h) =
(i) =
(j) =
(k) =
(l) =
(m) =
(n) =
(o) =
(p) =
TOTAL =
=