Module 2

THE ACCOUNTING EQUATION AND ANALYZING BUSINESS TRANSACTIONS

Learning objectives
1. Discuss the basic accounting equation.
2. Understand the concept of increase/decrease in an amount.
3. Identify the effects of transactions on the accounting equation.
4. Analyze the effects of different business transactions to the accounting equation.

The purpose of accounting is to provide a means of recording, reporting, summarizing, and

interpreting economic data. At the end of the period, a trustworthy and competently financial
reports are prepared and provided on a regular basis. To do this, an accounting system must be
designed.

Accounting information system is vital for keeping the data to become a document and
later a record. Once a system has been designed, reports can be issued, and decisions based
upon these reports are made for various departments and other users.

Occurrence of business transactions must be substantiated by the source documents like

an invoice, official receipts, purchase order, payroll and the like. Then it will be analyzed and
processed for recording aided by the accounting equation. The accounting equation represents
the relationship between assets, liabilities, and owner’s equity of a business. Finally, the summary
of transactions in the form of financial statements are provided to users.

What is the Accounting Equation Used for?

The basis of accounting is the principle of balance. To carry out economic activities, the
company needs funds and that these funds should be given to the company by owner/sole
proprietor. The funds owned by the company are called assets. The total amount of funds
contributed by them is called capital. If the owner is the only one who contributed, then the
equation is

Assets = Owner’s Equity

 However, assets may be contributed by someone else who is not the owner. The debt of the
company for these assets is called liabilities. Therefore, now the equation will take the following
form:

Assets = Liabilities and Owner’s Equity.

The left and right sides of the equation must always be equal regardless of the Number
of business transactions.

Three Elements in the Accounting Equation

1. Assets are things of value owned by a business.
• Cash
• Accounts receivable
• Notes receivable
• Supplies
• Prepaid Insurance
• Prepaid Taxes
• Merchandise Inventory (for Merchandising business)
• Equipment
• Furniture & Fixtures
• Land
• Building
• Patents
• Copyrights
2. Liabilities. Obligations owed to other companies and people classified as current and
long-term liabilities.
• Accounts Payable
• Notes Payable
• Mortgage Payable
• Salaries Expense
• Taxes Payable
• Interest Payable
• Unearned revenue

3. Capital. Equity of the owner. These are the financial resources or assets owned by a
business that are useful in furthering development and generating income. It is the
residual interest in the assets after deducting the liabilities of the business. Capital is
affected by the following:

Effect in the Capital

Owner’s investment increase
Owner’s withdrawals decrease
Revenue /Income increase
Expenses decrease
 ANALYZING BUSINESS TRANSACTIONS

In order to generate financial reports, business transactions have to be analyzed,

recorded and summarized. In analyzing transactions, the suggested procedures are as
follows:

1) Determine the accounts affected or involved in the transaction. There

are two or more accounts involved in every transaction.

2) Determine the effect of the transaction on the accounts involved in terms of

increase or decrease.

The accounts affected or involved and the effects of the transactions on the said
account are illustrated as follows: (INC - Increase; DEC – Decrease; NC - No Change)

Transactions Asset Liabil Capit Analysis

s ities al
An entity is separate and distinct from
the owner. Cash investment will both
1 Owner invests cash INC NC INC increase asset and capital.
Purchased supplies on Supplies is an asset and it was bought
2 credit INC INC NC on credit, both asset and liabilities
increase.

Equipment is an asset and since this is

an investment by the owner, both asset
3 Owner invests equipment INC NC INC and capital correspondingly increase.
Land increases the assets of the
4 Buys land paying cash INC/D business but cash as an asset
EC NC NC correspondingly decrease for cash
purchase of the land.
Cash increases the assets of the
business because of borrowed cash.
Notes Payable increases the liabilities of
5 Borrows cash with note INC INC NC the business as it represents an
obligation to pay in the future date.
6 Rendered services for Cash received increases asset and it
cash. INC NC INC was also an increase in capital due to
revenue earned.
Cash payments represent cash outflow
7 Paid utilities expense DEC NC DEC decreases assets while expenses
decrease capital as it has opposite
effect on income
Asset increased because of supplies
8 Paid supplies purchased. DEC NC DEC purchased and another asset, Cash
decreased because of payment.
Assets increased by the amount of
9 Rendered services on accounts receivable expected to be
account. INC NC INC collected from the customer and capital
increased since rendering of services
represents revenue.
 Asset increased as there was cash
inflow in the amount of the collection.
10 Collection of Accounts INC/D NC NC Another asset decreased in the amount
Receivable EC of accounts receivable collected.
Cash is an asset; a cash payment
12 Paid salaries of DEC NC DEC decreases asset. Correspondingly,
employees. salaries expense decreases income
and decrease in income is a decrease
in capital.
Asset decreased because of cash and
13 Cash withdrawal of the DEC NC DEC decreased in capital because of
owner for personal use. personal use.
Cash payment decreases asset and a
14 Payment of accounts DEC DEC NC decreased in liabilities because of
payable accounts payable.

Asset increased by the amount of tables

15 Purchased office tables and chairs (classified as furniture and
and office chairs. Paid INC/D INC NC fixtures), Asset decreased by the
down payment and the EC amount of cash payment. Liabilities
balance is due after increased by the amount of unpaid
30days. balance (accounts payable)

Illustrative Problem

The following details will include the amount and the account affected in illustrating the effects
on the accounting equation. Notice that the accounting equation is always balanced in every
transaction such that assets are always equal to liabilities and capital.

The Diaz Dry and Fold Shop, owned by Mr. Diaz, engaged in a laundry business completed the
following transactions during the first month of its operations, January 2020:

1. Mr. Diaz organized a laundry shop business owned and managed by himself. He
invested cash of P600,000 and deposited in the account of his business named Diaz
Dry & Fold Shop.

2. Purchased supplies in the amount of P30,000 cash.

3. Bought 4 units of washing machine and 4 units of dryer on account with the total
amount of P400,000.

4. Purchased office chairs and tables amounting to P50,000.

5. Paid space rental for the month, P 25,000.

6. Paid partial amount of P250,000 for the washing machine and dryers purchased in no.
3.

7. Received P75,000 from cash customer for the laundry services.

8. Paid light and water bills for the month, P35,000.

9. Charged customer for the laundry contract of hotel linens and curtains, P 150,000.
 10. Purchased additional supplies on account, P25,000.

11. Paid salary of laundry assistants, P40,000.

12. Mr. Diaz withdrew P10,000 cash for his personal use.

13. Collected 50% of laundry service charged in no. 9.

14. Purchased computer and printer, P40,000. Terms: Down payment of P10,000 and the
balance payable in two equal installments.

15. Paid local taxes to continue operate the business, P5,000.

Required: (1) Analyze the above transactions by using accounting equation tabulation and
indicate under the notation column why the capital of Diaz is affected.
(2) Prepare the financial statements for the month ended January 31, 2020.
ASSETS LIABILITIES CAPITAL
NOTATIONS
ACCOUNTS FURNITURE ACCOUNTS DIAZ,
RECEIVABLE AND CAPITAL
CASH SUPPLIES EQUIP- PAYABLE
FIXTURES
MENT

1 600,000 600,000 Initial

investment

2 (30,000) 30,000
3 400,000 400,000
4 (50,000) 50,000
5 (25,000) (25,000) Rent Expense

6 (250,000) (250,000)
7 75,000 75,000 Service
Revenue

8 (35,000) (35,000) Utilities Exp.

9 150,000 150,000 Service

Revenue

10 25,000 25,000
11 (40,000) (40,000) Salaries Exp.

12 (10,000) (10,000) Diaz

withdrawal
 13 75,000 (75,000)
14 (10,000) 40,000 30,000
15 (5,000) (5,000) Taxes Exp.

Bal. 295,000 75,000 55,000 50,000 440,000 205,000 710,000

To enhance the usefulness of the financial data and its balances from the tabulation, the following are
the summary of financial reports:

1) Statement of Income and Expenses

2) Statement of Owner’s Equity
3) Statement of Financial Position
4) Statement of Cash Flows

Diaz Dry and Fold Shop

Statement of Income and Expenses
For the Month Ended January 31, 2020

Service Revenue P225,000

Less: Operating Expenses
Salaries P 40,000
Utilities 35,000
Rent 25,000
Taxes 5,000
Total Operating Expenses 105,000

Net Income P120,000

Diaz Dry and Fold Shop

Statement of Owner’s Equity
For the Month Ended January 31, 2020

Diaz Capital, January 1, 2020 P600,000

Add: Net Income 120,000
Total 720,000
Less: Withdrawals 10,000
Diaz Capital, January 31, 2020 P710,000

Note: The capital balance at the beginning in the amount of P600,000 increased to
P710,000 at the end of the month because of the net increase in capital by
P110,000 due to greater amount of net income of P120,000 than withdrawals of
P10,000.
 Diaz Dry and Fold Shop
Statement of Financial Position
January 31, 2020

Assets Liabilities and Capital Cash

P295,000 Accounts Payable P205,000
Accounts Receivable 75,000 Diaz, Capital 710,000
Supplies 55,000
Furniture and Fixtures 50,000
Equipment 440,000
Total Assets P915,000 Total Liabilities and Capital P915,000

Diaz Dry and Fold Shop

Statement of Cash Financial Position
January 31, 2020

Cash Flows from Operations:

Service Revenues P75,000
Collection of Receivables 75,000
Purchased of Supplies (30,000) Payments of
Expenses:
Rent P25,000
Utilities 35,000
Salaries 40,000
Taxes 5,000 (105,000) P15,000

Cash Flows from Investment Activities:

Purchased of Equipment P(260,000)
Purchased of Furniture & Fixtures ( 50,000) (310,000)

Cash Flows from Financing Activities:

Investment of the Proprietor P 600,000
Withdrawals of the Proprietor ( 10,000) 590,000

Cash Balance, January 31, 2020 P295,000

 Note: 1. Cash balance at the end of the Statement of Cash Flows must always be
equal to the cash indicated in the statement of Financial Position.
2. The statement of Cash Flows explained the sources and uses of cash.

Activities and Assessment

EXERCISE 2-1. INSTRUCTIONS: On the space provided, indicate whether the normal
balance of each of the given account is DEBIT or CREDIT:

1. Building __________ 11. Interest Payable ___________

2. Supplies __________ 12. Land __________
3. Accounts Payable _________ 13. Drawing __________
4. Allow. for doubtful accts. ________ 14. Rent Expense _________
5. Notes Receivable __________ 15. Prepaid Insurance ___________
6. Mortgage Payable __________ 16. Equipment ___________
7. Commission Income _________ 17. Furniture & Fixtures _________
8. Cash __________ 18. Professional Fees ___________
9. Accumulated Depreciation _______ 19. Sales Salary _______________
10. Capital ___________ 20. Unearned Income ___________

EXERCISE 2-2. Write “T” if the statement is true and “F” if the statement is false.

_____1. The fundamental accounting equation is Assets = Liabilities + Capital

_____2. Revenue increases owner’s equity.
_____3. Payment of an expense increases asset.
_____4. Expenses decreases owner’s equity.
_____5. Receipt of cash decreases asset.

EXERCISE 2-3. Show the effects on the accounting equation. Write + for increase, - for
decrease, and NC for No Change.

Asset Liability Capital

1. Owner invested cash in the business
2. Owner borrowed money from the
bank
3. Purchased filing cabinets for cash.
 4. Owner purchased a printer on
account
5. Bought truck paying 10% down and
balance on account.
6. Paid account to creditors
7. Charged customer for the service
rendered.
8. Collected an account receivable
9. Purchased reams of bond paper in cash
10. Paid utilities for the month
11. Owner withdrew cash for personal use
12. Rendered service for cash

Exercise 2-4

A medical practioner Dr. Nikolai opened his clinic with the following initial transactions:
1. Dr. Niko opened a medical clinic by investing P300,000 pesos.
2. Issued a promissory note for the P100,000 he borrowed from Banco De Uno.
3. Purchased a medical bed and its accessories worth ₱100,000
4. Bought from A Co. a table and cabinet worth ₱70,000.
5. Purchased medical supplies in the amount of ₱25,000 cash.
6. Withdrew ₱20,00 for personal use
7. Purchased chairs on account for ₱15,000.
8. Paid 50% of account to A co.
9. Bought from SM Furniture cabinet shelves worth of ₱20,000. Paid ₱5,000 cash and
the balance on account.
10. Received P75,000 from the group of patients as medical fees.
11. Paid power and water bills for the month, P8,000.
12. Paid medical assistant salary, P20,000.
13. Charged the patients for attending the medical care, P50,000.
14. Paid the balance in full to SM Furniture.
15. Collected 70% of medical fees charged to patients in no.13.
16. Paid communication bills, P3,500.
17. Paid P6,000 to Petron Station for the gasoline of Dr. Nokolai’s service vehicle.
18. Settled a partial payment of P70,000 to Banco De Uno ( refer to item no. 2)
19. Purchased additional medical equipment, P50,000. Terms: Paid P30,000 and the
balance after 30 days.
20. Returned defective medical supplies purchased in no. 5, worth P5,000.
21. By taking inventory at the end of the period, medical supplies consumed amounted to
P18,000.

Required:
1) Analyze and record the transaction using the given tabulation below:
 A S S E T S LIABILITIES CAPITAL
Acct. Fur. & Accounts Mortgage Nikolai,
No. Cash Rec’ble Supplies Fixture Equipt. Payable Payable Capital Notations

2) Prepare the following financial reports for the month of January 2020:
a) Income Statement
b) Statement of Owner’s Equity
c) Statement of Financial Position
d) Statement of Cash Flows

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