CHAPTER II

THE ACCOUNTING EQUATION

Learning Outcomes

At the end of the chapter, learners shall be able to:

• Describe the accounting elements and values;

• Define business transaction and double-entry bookkeeping;
• State the accounting equation and use it to solve simple problems;
• Define chart of accounts;
• Enumerate and describe the account titles listed in the chart of
accounts; and
• Identify the account titles peculiar to service and merchandising
business.

Accounting Elements and Values

There are three essential elements of accounting. These are assets,

liabilities and capital/proprietorship or owner’s equity.

Assets are items of value owned and used by the business that will
benefit future operations.

Liabilities are obligations that the business owes from other individuals or
entities for the acquisition of goods and/or services.

Capital/Proprietorship or Owner’s equity represents the claim of the

owner in the assets of the business.

When assets, goods or services are acquired by a business, the amount

in which they are recorded is the price agreed upon in the business transaction.

A business transaction is where two parties exchange

things and/or rights of value which are expressed in terms of money.
This is called cost that resulted from the actions of an informed
buyer and an informed seller, both of whom are attempting to obtain
the most favorable prices or amount in the exchange.

An example of this is when the business enterprise would acquire a

computer and would be willing to pay P50,000 which the seller would approve.
The cost therefore is P50,000 which is the value to be used in recording the
transaction.

10
The Accounting Equation

The double-entry bookkeeping system is an accounting system commonly

used today. This is a logical and integrated system based on the original
hypothesis that “the value of the property equals the value of the rights on the
property”. This bookkeeping system considers the two-fold effect of a business
transaction where there is a value received and there is a value parted with.

In accounting, property is called “asset” and ownership’s right over the

property is known as “equity”. The relationship between the assets and equities
may be stated in an equation as follows:

ASSETS = EQUITIES

Equities may be subdivided into two principal types- the right of creditors
and the right of owners. The equities of the creditors are called liabilities and the
owner’s equity is called proprietorship or capital. Expansion of the equation to
give recognition to the two types of equities will result into an equation, known as
the “Accounting Equation”.

ASSETS = LIABILITIES + CAPITAL (PROPRIETORSHIP)

Factors affecting the Owner’s Equity

1. Investment of the owner includes his initial or original investment and
additional investment in cash, and/or non-cash assets like fixed
assets, and merchandise for the operation of the business.

2. Withdrawals of the owner are cash, fixed assets, and/or

merchandise taken by the owner for his personal use.

3. Revenues include income earned out of rendering services or through

selling of goods.

4. Expenses include costs incurred for expenditures in operating the

business.

The Expanded Accounting Equation

Due to the factors affecting the owner’s equity, the basic accounting
equation could be stated in an expanded form as follows:

ASSETS = LIABILITIES + INITIAL/ORIGINAL INVESTMENT

+ ADDITIONAL INVESTMENT
- WITHDRAWALS
+ REVENUES
- EXPENSES
The Chart of Accounts
The chart of accounts is a listing of all the account titles to be used in
recording business transactions. The account titles are being classified as to
what caption and statement they belong. The accounts that are reflected in the
Balance Sheet or Statement of Financial Condition are called real accounts
(assets, liabilities and capital), while accounts in the Income Statement or
Profit and Loss Statement are called nominal accounts (revenues, costs and
expenses).

The accounts are arranged in this manner - assets, liabilities, capital,

revenues and expenses, thus, the acronym ALCRE. Accounts are also assigned
codes for easy reference in the posting process.

The following is an example of a Chart of Accounts in a trading or merchandising

business:

ASSETS
Current Assets Non-Current Assets
Petty Cash Investments
Cash on Hand Investment in Stocks
Cash in Bank Investment in Bonds
Notes Receivable Property, Plant and Equipment
Accounts Receivable Land
Allowance for Doubtful Accounts Building
Interest Receivable Accumulated Depreciation-Building
Merchandise Inventory Equipment
Prepaid Rent Accumulated Depreciation-
Prepaid Insurance Equipment
Unused Supplies Furniture and Fixtures
Miscellaneous Prepaid Expenses Accumulated Depreciation-Furniture
& Fixtures
Tools
Intangible Assets
Franchise
Trademark
Patent

LIABILITIES
Current Liabilities Long-term Liabilities
Notes Payable Notes Payable
Accounts Payable Mortgage Payable
Accrued Salaries and Wages Loans Payable
Accrued Interest Payable Bonds Payable
Accrued Taxes Payable
Other Accrued Liabilities
Unearned Rent Income
 Unearned Commission Income
Unearned Interest Income
Withholding Tax Payable
Medicare Contributions Payable
PAG-IBIG Contributions Payable
SSS Contributions Payable

CAPITAL
Proprietor’s Name, Capital Proprietor’s Name, Drawing

REVENUES
Net Sales Other Income
Sales Interest Income
Sales Returns and Allowances Rent Income
Sales Discount Commission Income

COST OF GOODS SOLD

Purchases Freight in
Purchase Returns and Allowances Merchandise Inventory, beginning
Purchase Discount Merchandise Inventory, end

OPERATING EXPENSES

Salary Expense Freight out

Advertising Expense Bad Debt Expense
Depreciation Expense Supplies Expense
Commission Expense Insurance Expense
Rent Expense Light and Water Expense
Taxes and Licenses Repairs and Maintenance
Communication Expense Miscellaneous Expense
Interest Expense

The chart of accounts for a service business differs from that of a

merchandising business in the accounts used in the income statement for its
revenues. The principal sources of revenues for service businesses are
professional or service fees, rent income and commission income, hence these
are used. Therefore, Sales account and its related account titles, like Sales
Returns and Allowances and Sales Discounts including Purchases, Purchase
Returns and Allowances, Purchase Discounts, Merchandise Inventory and
Freight in are not included or are not used in a service business. Merchandise
Inventory account in the balance sheet is not also used.
Description of Account Titles
ASSETS
Current Assets include cash and other assets, which in the regular course of
the business are readily convertible into cash, used or consumed, usually within
one year from the balance sheet date. The current asset section of the balance
sheet may contain the following items:
Cash on Hand includes currencies (coins and paper bills) and miscellaneous
cash items already received by the business but not yet deposited in the
bank. Some examples of cash items are checks, bank drafts, money order
and treasury warrants.
Cash in Bank refers to the cash deposits at the bank readily available for the
operation of the business.
Petty Cash is a fund set aside for petty expenses which are not reasonably
paid by check.
Notes Receivables are amounts due or collectible from customers for goods
or services sold, or from others, which are evidenced by written promises
called promissory notes.
Accounts Receivables are amounts collectible on open account from
customers for services rendered or merchandise sold to them. They differ
from notes receivable because the accounts receivable is not supported by
written promises to pay.
Allowance for doubtful accounts or bad debts is a contra-asset account
item. It provides for possible losses from possible uncollectible accounts. It
is deducted from Accounts Receivable in order to present the estimated
amount of cash collectible from customers or the Net Realizable Value
(NRV).
Interest Receivable is the interest earned on notes receivable but not yet
received or collected.
Merchandise Inventory includes merchandise or goods bought by the
business which will be sold, sooner or later for profit and those still on hand
and ready for sale as of reporting date.
Prepaid Expenses are amounts paid in advance, which are applicable to
expenses of future periods. Examples are advance payments for rent,
commission and interest.
Unused Supplies or Supplies on Hand are supplies bought for use but still
unused as of the balance sheet date. Common examples are office supplies
like paper, ball pens, carbon paper, paper clips, staple wires, etc.

Non-Current Assets refer to assets that are not classified as current assets.
Investments are assets not directly identified with the operating activities of
the company or assets not involved in the sale or production of goods or
services. Thus, investments occupy only an auxiliary relationship or a
secondary role to the central activities of the enterprise. They represent
stockholdings acquired for the purpose of controlling another firm or creating
good customer-supplier relationship. Examples are investment in stocks and
investment in bonds.
Property, Plant and Equipment/Fixed Assets are assets which are
permanent in nature and acquired for use rather than for resale. Examples of
fixed assets are:
Land is the lot owned by the business on which the building used for
business is built.
Building is the structure owned and used by the business. This also
includes major repairs of the building.
Equipment includes office equipment like printers, computers,
calculators, cash registers and the like; delivery equipment like delivery
van, delivery truck and wagon; and other equipment, which are primarily
used in the operation of the business.
Furniture and Fixtures include tables, chairs, counters, showcases,
shelves, dividers and similar assets owned by the business for its
operation.
Tools are necessary assets used by shops extending services to the
public.
Accumulated Depreciation is another contra-asset item. It represents
the total depreciation expenses of the past and current periods. It is a
valuation account that reduces the total cost of fixed assets to its Net
Book Value (NBV).
Intangible Assets are relatively long-lived assets without physical
characteristics whose value lies in rights, privileges and competitive
advantage which they give the owner. Examples are franchises, trademarks
and patents.

Franchise is a contract-based intangible asset. It may be between the

government and a private entity or individual or between private entities
or individuals.

Patent is an exclusive right granted by the government to an inventor

enabling the grantee to control the manufacture, sale or other use of the
invention for a specified period of time.

Trademark is a symbol, sign, slogan or name used to mark a product to

distiguish it from other products.
LIABILITIES

Current Liabilities are obligations or debts payable by the business to the

creditors and are expected to be paid or liquidated within the operating cycle of
the business. This section of the balance sheet may contain the following:
Notes Payable are unpaid promissory notes given to creditors for money
borrowed, merchandise and/or other assets bought and services acquired on
credit.
Accounts Payable are obligations or debts payable by the business to other
parties for services acquired or merchandise and/or other assets purchased
on credit not evidenced by a promissory note.
Accrued Expenses are expenses already incurred but not yet paid. These
may include unpaid salaries, taxes already due, unpaid interest and similar
items.
Unearned Income includes income from rent, interest or commission that
has already been received in advance but the corresponding service has not
yet been rendered.
SSS, PAG-IBIG and Medicare Contributions Payable refer to the
employer’s contributions paid as benefit to employees.

Long-term Liabilities are obligations of the business with maturity dates beyond
one year from reporting date.
Notes Payable are obligations supported by promissory notes that are
payable or due after one year.
Mortgage Payable are obligations which are evidenced by a mortgage of
real properties (Real Estate Mortgage) or personal properties (Chattel
Mortgage).
Loans Payable are obligations of the business to individuals or financial
institutions for money borrowed payable beyond one year from balance sheet
date.
Bonds Payable are long-term promissory notes under seal which are issued
to the public.

PROPRIETORSHIP
Name of the proprietor, Capital represents the total investment of the
owner.
Name of proprietor, Drawing or Personal represents withdrawals or
amount of cash and/or other assets taken by the owner from the business for
personal use.
INCOME STATEMENT ACCOUNTS
Sales are revenues derived from selling goods to customers. These are the
sources of revenues for both merchandising and manufacturing businesses.
Sales Returns and Allowances refer to the deductions from the invoice
prices due to damages, defects or errors in the kind or quality of merchandise
delivered to the customers.

Sales Returns account is used when there is a physical return of goods,

while Sales Allowances account is used when damages/defects on goods
delivered are settled by a reduction in the invoice price. However, the
account Sales Returns and Allowances is used whether an actual return
was made or not.
Sales Discounts represent the deductions allowed to customers because of
prompt payments of their accounts.
Rent Income is the revenue earned by owners of apartments, boarding
houses or condominiums, building lessors and market stall lessors. These
are income earned from allowing another party to use the assets of the
business.
Income from Fees or Service Income refers to the revenue earned for
rendering services by motor repair shops, advertising agencies, airlines,
lawyers, dentists, hospitals, etc.
Commission Income is the revenue earned by real estate brokers,
insurance agents and travel agencies.
Interest Income is the revenue earned from lending money.
Purchases refer to the gross cost of merchandise bought.
Purchase Returns and Allowances are deductions from invoice cost due to
returns, damages, defects or errors in the kind or quality of merchandise
received.
Purchase Discounts are reductions in the cost of merchandise bought due
to early payment.
Freight in refers to the cost of transporting or shipping the goods bought.
Merchandise Inventory refers to goods unsold as of a given date.
Salary Expense refers to the amount paid for the services of employees
working in the business.
Advertising Expense is the cost of publications in the newspapers, calling
cards, billboards and propaganda through radios and televisions.
Depreciation Expense is the portion of the cost of fixed assets like building,
furniture and fixtures and equipment, which are allocated to the current
period. It is an estimate for the period of the decrease in the value of the
asset due to obsolescence and wear and tear.
Commission Expense refers to the cost paid to an agent for services
rendered.
Rent Expense is the amount paid for the use of a space for the store,
working area or office of the business.
Taxes and Licenses include business taxes, licenses, registration fees and
other fees paid to the government.
Communication expense includes amounts incurred for communications
being used or consumed by the business such as postage, telephone bills,
prepaid cards and internet fees.
Freight out or Delivery Expense refers to the cost of gasoline and oil used
and other related expenses incurred in transporting goods to customers.
Bad Debt Expense or Doubtful Accounts Expense refers to losses from
accounts receivable that proves to be uncollectible or doubtful of collection.
Supplies Expense refers to the cost of supplies used or consumed during
the period.
Insurance Expense refers to costs paid to insurance companies for the
financial protection or reimbursement from losses such as fire, flood, and
other calamities.
Light and Water Expense or Utilities Expense refers to the cost of
electricity and water consumed.
Repairs and Maintenance Expense refers to the cost of repairing and
servicing (materials plus labor) certain assets like building, furniture and
fixtures and equipment.
Interest Expense refers to the cost of borrowing money used by the
business.
EXERCISE 2-1. TRUE OR FALSE. Write “T” if the statement is true and “F” if
the statement is false.

____1. The accounting equation: assets = equities means that asset

equal all vested rights of persons (owners and creditors).
____2. The equity of persons other than the owners of the business is
called liabilities.
____3. The term “equities” includes all the rights or claims of persons in
the assets of the business.
____4. The term “assets” includes everything owned or possessed by the
business capable of being expressed in terms of money.
____5. Expenses incurred by the business increase the owner’s equity.
____6. Merchandise Inventory account is being used by both
merchandising and service businesses.
____7. Accounts Payable is the amount collectible on open account from
customers for services rendered and/or merchandise sold to them.
____8. Notes Payable are an obligation or debt payable by the business to
other parties for services acquired or merchandise purchased on
credit not evidenced by a promissory note.
____9. Unearned income is a liability account because it has been
received in advance but the corresponding service has not yet
been rendered.
____10. Sales returns and allowances are deductions from the invoice cost
due to damages, defects or errors in the kind or quality of
merchandise received.
____11. Cost is the exchange of goods or services for a certain sum of
money or its equivalent.
____12. Items that are more or less permanent in nature, used in the
operations of the business and not intended for sale are called
current assets.
____13. The basic accounting equation is Assets = Liabilities + Capital
____14. The amounts which the owner has taken away from the business
either in the form of cash or merchandise, thereby, decreasing the
proprietorship are called expenses.
____15. Single-entry system is a logical and integrated system based on
the hypothesis that the value of property equals the value of the
rights on it.
EXERCISE 2-2. MATCHING TYPE. Select the terms in Group I that matches
the description made in Group II.

Group I

A. Mortgage Payable N. Accrued Salaries Payable

B. Liabilities O. Office Supplies Expense
C. Notes Receivable P. Maintenance & Repairs Expense
D. Land Q. Rent Income
E. Building R. Depreciation Expense
F. Equities S. Utilities Expense
G. Assets T. Freight Out
H. Accounting Equation U. Advertising Expense
I. Expanded Accounting Equation V. Notes Payable
J. Interest Income W. Accounts Receivable
K. Unearned Interest X. Taxes and Licenses
L. Merchandise Inventory Y. Rent Expense
M. Accrued Interest Receivable

Group II

____1. Claims of the creditors on the assets of the business.

____2. Ownership rights in the property of the business.
____3. Items of value owned by the business.
____4. Assets = Liabilities + Proprietorship + Revenue – Expenses
____5. Interest earned but not yet received.
____6. Amounts collectible from customers for services rendered and
merchandise sold to them which are evidenced by a promissory
note.
____7. Long-term debt which a property has been given as collateral.
____8. Commodities or goods bought by the business which are
intended for sale.
____9. Interest that has already been received but not yet earned.
____10. Salaries of employees that are not yet paid as of the balance
sheet date.
____11. Cost of repairing or servicing assets particularly equipment.
____12. Cost of stationery, ball pens, and others which are consumed or
used.
____13. The allocation of the cost of certain assets like building and
equipment and others over their estimated useful life.
____14. Cost of electricity and water consumed.
____15. Cost of gasoline and oil used and other expenses in transporting
goods to customers.
EXERCISE 2-3. MULTIPLE CHOICE. Encircle the letter that corresponds to the
best answer.
1. It is the amount agreed upon by the seller and the buyer as an exchange
price.
a) cost b) assets c) revenue d) all of these

2. The relationship between assets and equities maybe stated in an

equation as:
a) Assets = Equities c) Equities = Liabilities
b) Assets = Proprietorship d) Assets = Liabilities

3. Which of the following does not affect the owner’s equity?

a) revenues b) withdrawals c) investment d) none of these

4. If the total assets of the business is P180,000 and its total liabilities is
P90,000, the total equities of the business is:
a) P 100,000 b) P180,000 c) P 90,000 d) none of these

5. If the business has P850,750 worth of assets and P250,000 worth of

liabilities, the proprietor’s capital would be:
a) P600,000 b) P600,750 c) P 850,750 d) none of these

6. If the business has only two classes of assets - Current Assets of

P400,000 and Fixed Assets of P475,000, what is the amount of the total
equities?
a) P 475,000 b) P 875,000 c) P 400,000 d) none of these

7. Refer to No. 6 above. If the total Capital or Owner’s Equity is P600,000,

what is the total obligation of the business to outsiders?
a) P 275,000 b) P 300,000 c) P 25,000 d) none of these

8. Refer to number 6 above. If the total obligation of the business is

P100,000, the total owner’s equity is:
a) P 575,000 b) P 675,000 c) P 300,000 d) none of these

9. Mr. Go Shoktong decided to put up a physical fitness center and initially

invested P30,000 cash and P70,000 worth of physical fitness equipment.

What is the amount of the total assets of Mr. Shoktong’s business just
after his initial investment?
a) P30,000 b) P100,000 c) P70,000 d) none of these
10. In addition to the information in number 9, the business earned a total
revenue from fees of P84,000, and incurred P 26,000 total expenses
during the semester. The business also incurred an obligation of P
15,000 for the purchase of additional physical equipment. Mr. Shoktong
withdrew P16,000 cash for personal use.

Using the expanded accounting equation, what is the amount of total

assets of the business just after the end of the semester?
a) P157,000 b) P175,000 c) P100,000 d) none of these

11. Elizabeth Hamilton established a day care center and initially invested
the following: cash of P100,000; furniture and fixtures worth P150,000;
and books and toys costing P50,000. She transferred to her business
the unpaid balance on the furniture and fixture amounting to P30,000.

What is the amount of the total assets of Hamilton’s business just after
her initial investment?
a) P300,000 b) P330,000 c) P270,000 d) none of these

12. In addition to the information in number 11, the business incurred an

obligation of P25,000 for the purchase of additional books and toys.
Hamilton withdrew P20,000 cash for personal use. Also, during the
accounting period, the business paid one-half of the liability on the
furniture and fixtures; earned a total revenue from fees of P105,000, and
incurred P63,000 total expenses.

Using the expanded accounting equation, what is the total capital of

Hamilton at the end of the accounting period?
a) P267,000 b) P292,000 c) P277,000 d) none of these

13. Using the expanded accounting equation, what is the total assets of the
business at the end of the accounting period?

a) P332,000 b) P342,000 c) P300,000 d) none of these

14. What is the total liabilities of the business at the end of the accounting
period?

a) P55,000 b) P30,000 c) P40,000 d) none of these

15. How much income did the business earn?

a) P105,000 b) P42,000 c) P17,000 d) none of these

EXERCISE 2-4. COMPUTATION. Compute for the missing amounts.

Owner’s
Assets = Liabilities +
Equity

a) 250,000 140,000

b) 135,000 69,000

c) 560,000 190,000

d) 135,000 20,000

e) 170,000 75,000

f) 120,000 75,000

g) 1,000,000 402,000

h) 200,200 150,000

i) 120,000 54,000

j) 1,034,000 1,808,000

k) 526,000 409,000

l) 309,200 153,900

m) 1,239,000 452,630

n) 185,000 125,900

o) 620,300 2,950,600

p) 900,000 198,000

q) 1,789,000 220,000

r) 2,650,000 450,300

s) 200,900 452,000

t) 950,000 779,000