TheLesson

Five Major Accounts

4: The
Accounting
Equation
ACCOUNTING EQUATION
• Shows the resources of the company, its obligations and the net
asset of the business.
• BASIC ACCOUNTING EQUATION: ASSETS = LIABILITIES +
EQUITY
• EXPANDED ACCOUNTING EQUATION: ASSETS =
LIABILITIES + EQUITY +
REVENUE – EXPENSES
• Always remember that just like any equation, two sides of the
equation should always be BALANCED.

ELEMENTS OF THE ACCOUNTING EQUATION

1. Assets
• There are the resources that an entity owns in order
to derive some future benefits.
• The main feature of these assets is their capability to
give benefits to the entity.

2. Liabilities
• These are the claims of external parties from the entity
usually creditors, suppliers and government.
• These are the obligations of the entity.

3. Equity
• These are the claims of the owners or the net assets of
the owners of an entity.
• Generally, equity comes from two sources:
A. Comes directly from the owners in the form of
investment
B. Comes from the operations of the entity
(INCOME OF THE BUSINESS)

REVENUE – EXPENSES = NET INCOME / NET LOSS

✓ REVENUES
• A business earns revenue when it sells its product or
services.

✓ EXPENSES
• Cost associated in selling products or performing services.

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ELEMENTS OF ACCOUNTING
The three major elements of accounting are: Assets, Liabilities, and Capital.

These terms are used widely in accounting so it is necessary that we take

a close look at each element. But before we go into them, we need to
understand what an "account" is first.

What is an Account?
In accounting, an account is a descriptive storage unit used to collect and
store information of similar nature.

For example, "Cash".

Cash is an account that stores all transactions that involve cash receipts
and cash payments. All cash receipts are recorded as increases in "Cash"
and all payments are recorded as deductions in the same account.

Another example, "Building". Suppose a company acquires a building

and pays in cash. That transaction would be recorded in the "Building"
account for the acquisition of the building and a reduction in the "Cash"
account for the payment made.

Now, let's take a look at the accounting elements.

ASSETS
Assets refer to resources owned and controlled by the entity as a result of
past transactions and events, from which future economic benefits are
expected to flow to the entity. In simple terms, assets are properties or
rights owned by the business. They may be classified as current or non-
current.

A. Current assets – Assets are considered current if they are held for the
purpose of being traded, expected to be realized or consumed within
twelve months after the end of the period or its normal operating cycle
(whichever is longer), or if it is cash. Examples of current asset accounts
are:
1. Cash and Cash Equivalents – bills, coins, funds for current
purposes, checks, cash in bank, etc.

2. Receivables – Accounts Receivable (receivable from

customers), Notes Receivable (receivables supported by
promissory notes).

• Allowance for Doubtful Accounts – This is a valuation account which

shows the estimated uncollectible amount of accounts receivable. It is a
contra-asset account and is presented as a deduction to the related asset
– accounts receivable.
3. Inventories – assets held for sale in the ordinary course of business
4. Prepaid expenses – expenses paid in advance, such as,
Prepaid Rent, Prepaid Insurance, Prepaid Advertising, and
Office Supplies
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 B. Non-current assets – Assets that do not meet the criteria to be
classified as current. Hence, they are long-term in nature – useful for a
period longer that 12 months or the company's normal operating cycle.
Examples of non-current asset accounts include:
1. Long-term investments – investments for long-term purposes
such as investment in stocks, bonds, and properties; and funds
set up for long-term purposes

2. Land – land area owned for business operations (not for sale)

3. Building – such as office building, factory, warehouse, or store

4. Equipment – Machinery, Furniture and Fixtures (shelves, tables,

chairs, etc.), Office Equipment, Computer Equipment, Delivery
Equipment, and others

• Accumulated Depreciation – This is a valuation account which

represents the decrease in value of a fixed asset due to continued use,
wear & tear, passage of time, and obsolescence. It is a contra-asset
account and is presented as a deduction to the related fixed asset.
5. Intangibles – long-term assets with no physical substance, such
as goodwill, patent, copyright, trademark, etc.

6. Other long-term assets

LIABILITIES
Liabilities are economic obligations or payables of the business.
Liabilities represent claims by other parties aside from the owners
against the assets of a company.
Like assets, liabilities may be classified as either current or non-current.

A. Current liabilities – A liability is considered current if it is due within

12 months after the
end of the balance sheet date. In other words, they are expected to be paid in
the next year.
If the company's normal operating cycle is longer than 12 months, a liability is
considered
current if it is due within the operating
cycle. Current liabilities include:
1. Trade and other payables – such as Accounts Payable, Notes
Payable, Interest Payable, Rent Payable, Accrued Expenses, etc.

2. Current-portion of a long-term liability – the portion of a

long- term borrowing that is currently due.

Example: For long-term loans that are to be paid in annual

instalments, the portion to be paid next year is considered current
liability; the rest, non-current.

3. Current tax liabilities – taxes for the period and are currently payable

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 B. Non-current liabilities – Liabilities are considered non-current if
they are not currently payable, i.e. they are not due within the next 12
months after the end of the accounting period or the company's normal
operating cycle, whichever is shorter.
In other words, non-current liabilities are those that do not meet the
criteria to be considered current. Non-current liabilities include:
1. Long-term notes, bonds, and mortgage payables;

2. Deferred tax liabilities; and

3. Other long-term obligations

CAPITAL/OWNER’S EQUITY
Also known as net assets or equity, capital refers to what is left to the
owners after all liabilities are settled. Simply stated, capital is equal to
total assets minus total liabilities. Capital is affected by the following:
1. Initial and additional contributions of owner/s (investments),

2. Withdrawals made by owner/s

3. Income, and

4. Expenses.

Owner contributions and income increase capital. Withdrawals and expenses

decrease it.

The terms used to refer to a company's capital portion varies according

to the form of ownership. In a sole proprietorship business, the capital is
called Owner's Equity or Owner's Capital; in partnerships, it is called
Partners' Equity or Partners' Capital; and in corporations, Stockholders'
Equity.

In addition to the three elements mentioned above, there are two items
that are also considered as key elements in accounting. They are income
and expense. Nonetheless, these items are ultimately included as part of
capital.

INCOME
Income refers to an increase in economic benefit during the accounting
period in the form of an increase in asset or a decrease in liability those
results in increase in equity, other than contribution from owners.

Income encompasses revenues and gains.

Revenues refer to the amounts earned from the company’s ordinary

course of business such as professional fees or service revenue for
service companies and sales for merchandising and manufacturing
concerns.

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 Gains come from other activities, such as gain on sale of equipment,
gain on sale of short-term investments, and other gains.

EXPENSE
Expenses are decreases in economic benefit during the accounting
period in the form of a decrease in asset or an increase in liability that
result in decrease in equity, other than distribution to owners.

Expenses include ordinary expenses such as Cost of Sales, Advertising

Expense, Rent Expense, Salaries Expense, Income Tax, Repairs
Expense, etc.; and

Losses such as Loss from Fire, Typhoon Loss, and Loss from Theft.
Like income, expenses are also measured every period and then closed
as part of capital.

Net income refers to all income minus all expenses.

A. For each item, indicate whether it is an Asset, a Liability, or Capital in

Column A. If the item is an asset or a liability, indicate if it is Current or Non-
current in Column B. If the item is capital, place N/A in Column B.
A B

1. Tools and equipment Asset Non-current

2. Salaries payable

3. Additional investment of owner

4. Cash on hand

5. Cash deposited in Prime Bank

6. Delivery truck

7. Obligation to pay supplier

8. Loan from bank, 5 years

9. Investment in long-term bonds

10 Prepaid insurance
.
11 Patent (an intangible)
.

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12. Withdrawals made by owner

13. Merchandise for sale

14. Building used as office space

15. Accounts receivable

B. For each item, indicate whether it is an Income or an Expense. If it is

neither income nor expense, write its proper classification.

1. Rent revenue Income Expense

2. Rent payable

3. Salaries of employees

4. Sales

5. Light, water, and electricity

6. Loss from flood

7. Accumulated depreciation

8. Prepaid advertising

9. Delivery costs

10. Gain on sale of land

C. For each of the following accounts, indicate whether it is an Asset, Liability,

Income, or Expense. If it is an asset or a liability, specify whether it is current or
non-current.

1. Merchandise Inventory Asset Current

2. Accounts Payable

3. Utilities Expense

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4. Service Revenue

5. Computer Equipment

6. Office Supplies

7. Bonds Payable

8. Land

9. Cash

10. Furniture and Fixtures