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The Accounting Equation

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3 views

The Accounting Equation

djh

Uploaded by

m.pedrigosa
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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The Accounting Equation

The Basic Accounting Equation


All the processes in an accounting system must observe the equality of the
accounting equation, which is basically an algebraic equation. The basic
accounting equation is shown below:

ASSETS - are the economic resources you control that have resulted from
past events and can provide you with economic benefits.
LIABILITIES - are your present obligations that have resulted from past events
and can require you to give up economic resources when settling them.
Obligation
Obligation means a duty or responsibility. An obligation is either:
a. Legal obligation - an obligation that results from a contract, legislation,
or other operation of law; or
b. Constructive obligation - an obligation that results from your past
actions (e.g., past practice or published policies) that have created a
valid expectation on others that you will accept and discharge certain
responsibilities.

Giving up of economic resources


Settling the obligation necessarily would require you to pay cash, to transfer
other non-cash assets, or to render a service.

Present obligation as a result of past events


A present obligation exists as a result of past events if:
a. you have already obtained economic benefits or taken an action; and
b. as a consequence, you are required to transfer an economic resource.
EQUITY - is simply assets minus liabilities. Other terms for equity are "capital,"
"net assets," and "net worth."

Illustration 1:
You decided to put up a barbeque stand and have estimated that you will be
needing P2,000 as start-up capital. You then went to your closet and broke Mr.
Piggy Bank, which you have been saving for quite some time now. Alas! You
only have 800. You went to your Mama and asked her to give you $1,200 but
she told you that she has been feeding you for far too long. Oh man! But don't
give up hope yet, Mr. Bombay is just around the corner.
As of this point, your accounting equation is as follows:

Notes:

● Your total assets are P800 - the amount of economic resources that you
control.
● You don't have any liability yet because you are still negotiating with Mr.
Bombay.
● Your equity is also 800 (800 assets - 0 liabilities = 800 equity).

After a lengthy negotiation, Mr. Bombay agreed to lend you P1,200.

As of this point, your accounting equation is as follows:

Notes:

● Your total assets are now P2,000 - the total amount economic
resources that you control (P800 from Mr. Pigg plus P1,200 from Mr.
Bombay).
● Of your total assets of $2,000:
a. P1,200 represents your liability, the amount you an obligated to pay
Mr. Bombay in the future.
b. P800 represents your equity (i.e., P2,000 assets - P1,200 liabilities).
Liabilities represent the creditors' claim, while equity represents the
owner's claim, against the total assets of the business.
Original form of the equation:
Assets = Liabilities + Equity
2,000 = 1,200 + 800

Variation #1:
Assets - Liabilities = Equity
2,000 - 1,200 = 800

Variation #2:
Assets - Equity = Liabilities
2,000 - 800 = 1,200

The Expanded Accounting Equation


We can expand the basic accounting equation by including two income and
expenses. The expanded accounting equation shows all the financial
statement elements. The expanded accounting equation is as follows:

Assets = Liabilities + Equity + Income - Expenses


Notice that income is added while expenses are deducted in the equation.
These are because income increases equity while expenses decrease equity.
INCOME - is increases in economic benefits during the period in the form of
increases in assets, or decreases in liabilities, that result in increases in equity,
excluding those relating to investments by the business owner.

EXPENSES - are decreases in economic benefits during the period in the form
of decreases in assets, or increases in liabilities, that result in decreases in
equity, excluding those relating to distributions to the business owner.
The difference between income and expenses represents profit or loss.

⮚ If income is greater than expenses, the difference is profit ('profit'


means 'kita' or 'tubo' in Filipino).
⮚ If income is less than expenses, the difference is loss ('loss' means 'lugi'
in Filipino).

We can make another variation to the equation above as follows:


Asset = Liabilities + Equity + Profit/ - Loss
Profit increases equity while loss decreases equity.

Illustration 2: (Continuation of 'Illustration 1' above)


During the period, you earned income of P10,000 and incurred expenses of
P6,200.
At the end of the period, your total assets increased from P2,000 to
P5,000 and your total liabilities decreased from P1,200 to P400.
* Your expanded accounting equation is as follows:
Asset = Liabilities + Equity + Income - Expenses
5,000 = 400 + 800 + 10,000 - 6,200

We can also derive the following variation from the equation above:
Asset + Expenses = Liabilities + Equity + Income
5,000 + 6,200 = 400 + 800 + 10,000
Your profit for the period is P3,800 (P10,000 income minus P6,200 expenses).
There is profit because income is greater than expenses.
A variation of the expanded accounting equation is shown below:
Asset = Liabilities + Equity + Profit
5,000 = 400 + 800 + 3,800

Income and expenses (or profit or loss) are closed to equity at the end of each
accounting period. Thus, the adjusted ending balance of equity is computed
as follows:
Equity, beginning 800
Add: Income 10,000
Less: Expenses (6,200)
Equity, ending 4,600

OR
Equity, beginning 800
Add: Profit 3,800
Equity, ending 4,600

* Your basic accounting equation at the end of the accounting period is as


follows:
Assets = Liabilities + Equity
5,000 = 400 + 4,600

Notice that regardless of its form or variation, the accounting equation (basic
or expanded) remains balanced.

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