LESSON 4- ACCOUNTING EQUATION

Objectives
At the end of this lesson, the students should be able to:
1. define the accounting equation;
2. enumerate and explain the elements of the accounting equation; and
3. solve basic problems applying the accounting equation.

OVERVIEW REGARDING THE ACCOUNTING EQUATION

1.That the accounting equation is assets = liabilities + equity
2 That for every transaction, the accounting equation should always be balanced
3. That assets are resources owned by the business. ask them to enumerate or give an example of assets
4. That liabilities are obligations by the business. ask them to enumerate or give an example of liabilities
5. 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.
6. That there are four elements that affect equity: (1) investment; (2) withdrawal; (3) revenue, and; (4)
expenses.

Basic Accounting Equation

The equation has two (2) elements which is equally divide the entity into two parts the left side of the equation
represents what the entity owns. on the other hand, the right side represents those that the company owes.

ASSETS = LIABILITIES + EQUITY

The left side of the equation represents what the company owns. these are resources that the entity controls in
order to attain future benefits. the right side represents the claims of the different parties to the company’s assets.
liabilities represents the claims of the entity’s creditors while equity represents the residual interest of the owners of the
entity.

ASSET
EXAMPLES OF THESE ASSETS ARE:

1. Cash – money that we use comprising of the bills and coins.

2. Accounts receivable – represents amounts that are collectibles from customers. they arise when a business sells its
goods or services on account or on credit.
3. Inventories – piles of assorted products being offered to be sold.
4. Equipment – equipment/machineries used in the business.
5. Land and building – in businesses ,a physical store is necessary for them to operate. for example, how can a local
carenderia function without an actual store? where will a barber shop operate without its building? Such buildings are also
assets of the businesses. These buildings are owned by the company so that they can use them for their business to
operate.
6. Intangible assets – when we think of the things we can own, we normally think of tangible things or those that can be
seen nor touched.
For example, the software used by computer shops are actually assets that they own. even though one cannot
actually touch the software, its still an asset of the computer shop that will earn the shop future benefits.

LIABILITIES- are one of the claims of external parties from the entity. they are the debts of the entity to external creditors.
these debts do not always have to be paid in money. some of these liabilities are in the form of obligations to do some
service or even give something. these liabilities can take form in the following:
1. Accounts payable – when a local supermarket or convenience store like 7-eleven buys its goods, it is unusual for
it to immediately pay cash for such goods. normally , it would only incur an obligation to pay its suppliers after a certain
number of days. ( 30 days payable )
2. Unearned revenue – telecommunication companies such as globe and smart offer prepaid load to customers.
these load credits can be later on used by customers for text messages or to call other people. when globe and smart
receive payments from customers, it creates an obligation for them to actually deliver that services. such obligations to
give service are recorded as liabilities.

EQUITY- reflects the residual claims or net assets of the owners of an entity. this is similar to the net worth part of the SALN
of our public servants. take note that these are only residual claims of the owners since the creditors get their share of the
entity first before the owners are given their share. this is also why the net worth of individuals is computed by subtracting
their liabilities from their assets.
Equity comes from two sources. the first one comes directly from the owners in the form of investments of
capital. the other one comes from the income of the business from its normal operations. the net income or net loss of
the business from its operations can be determined by using the following equation:
revenues – expenses = net income/(net loss)

EQUITY:

1. Revenues – a business earns revenue when it sells its products or its services
2. Expenses – matching principles states that no revenue can be earned without incurring corresponding expenditures
3. Capital – the capital account of the entity represents the net investments of the business. this means that any
contribution of the owner which increases the assets of the business or decreases its liabilities will increase the capital
account. note that it does not only have to be cash to increase the capital account . an owner may even contribute
equipment or land to increase his or her capital.

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

Borrowings from the bank

July 2 – Reyes borrowed PHP100,000 cash from PNB for use in his business.

Asset purchased for cash

July 7 – Bought tables and chairs from Orocan and paid PHP45,000 cash

Assets purchased on account

July 15 – Various equipment were purchased on account from Fortune for PHP55,000

Cash withdrawal by the owner

 July 18 – Reyes made a cash withdrawal of PHP5,000 for personal use.

Payment of liability

July 20 – The account due to Fortune was paid in cash

The following table summarizes the effects of these transactions on the accounting equation

Determining profit through operation

1. Basis of accounting vs cash basis of accounting – accrual basis recognizes revenue when earned and recognizes expenses
when incurred
2. Under the expense recognition principle, expenses can be recognized either as: (1) matching; (2) systematic allocation,
or; 3) direct association.
3. 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.

Paid cash for expenses incurred

July 22 – Cash was paid for the following : gas and oil, PHP500 and car repairs, PHP1,000.
Revenue rendered on account

July 24 – Another customer hired the services of Reyes and promised to pay PHP16,000 on July 31.

Paid for expenses incurred

July 25 – Paid PHP500 for telephone bill.

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

Customer’s account collected in cash

July 30 – The customer on July 24 paid 50% of his account in cash.

Paid cash for expenses incurred

July 31 – Paid PHP10,000 for rental of office space, and salaries of PHP9,000
ACTIVITY: Lesson 4- Accounting Equation
For each transaction, tell whether the assets, liabilities and equity will increase (I), decrease (D) or is
not affected (NA).