Module 2

The Accounting Equation

i!flll Obie.ctw .·
At the end of the session, students will be
able to:

1. Analyze business transaction;

2. Perform operations involving
• Analyzing Business Transactions simple cases with the use of
• The Accounting Equation accounting equation
o Formula 3. Explain the accounting elements
o Elements of the Accounting that is used in the accounting
Equation equation;
o Effects of transactions to 4. Solve problems Ydafive to
accounting equation accounting equation; and
o Major Account Titles s. Explain the effects of different
transactions to the accounting
equation ; and
6. Differentiate the different account
titles used by the business

Analyzing Business Transactions

An accounting system must record all business transactions to ensure complete and reliable
information when the financial statements are prepared. Hence, a business transaction is an activity or event
that can be measured in terms of money and which affects the financial position or operations of the business
entity.

Each time a company makes a financial transaction, it generates some paper trail. Accountants call
this paper trail a source document or documents. If a small business writes a check from its checking account
for office suppftes, for example, the check and office supplies receipt become the source documents.

The source document is essential to the bookkeeping and accounting process as it provides evidence
that a financial transaction has occurred. It describes all the basic fact$ Of the transaction , such as the amount
of the transaction, to which the transaction was made, the purpose of the transactiOn,Jffid the transaction
date.

Types of Source Documents

1. Invoices are documents listing goods or services provided, as well as their prices.
They are the primary source documents for sales and similar forms of income.

2. Receipts are documents confirming that cash or goods have been received . It normally relate to
payment that has been made by cash or through a debit or credit card.

3. Cheque is a common form of payment, instructing a bank to transfer money from one bank account
to another.

4. Purchase Order is a source document issued by the buyer to the seller. Initially, it requests a
product or a service, but It is a binding agreement once the seller accepts the purchase order.
 s. Sales Order is a document generated by the seller upon receiving a purchase order from a buyer.
To accept the purchase order, the seller issues an order confirmation specifying the product details:
the product or service with the price, the quantity, the delivery terms, and the seller and buyer details.

6. Delivery Note is a document that is sent together with a shipment of goods that provides proof
that
the goods or products have been delivered . It usually shows the names of the parties, delivery
location, the date, and the descriptions and quantities of it ems in the transaction.

7. Debit Note can be sent from the buyer to the seller together with returned goods. In this
case, the
buyer notifies the seller that they do not intend to pay for the goods if purchased on credit, or
they
expect a refund or credit from the seller if goods have already been paid for.

8. Credit Note can be sent by the seller when the buyer has returned the product to the seller, fully or
partially. In this case, the credit note indicates that the buyer does not need to pay for these products
if purchased on credit, or that the seller now owes the buyer a refund, if the buyer already paid for
the
products.

9. Time Card is an internal document that companies use for registering the working hours of the
personnel and pay wages. The time card records the name of the employee, the working day,
the
entry time and the exit time.

10. Bank Statement is used to enter payments into the accounting system and match them to invoices.

The Accounting Equation

The fundamental accounting equation represents the relationship between the assets, liabilities,
and owner's equity of a person or business. It is the foundation for the double-entry bookkeeping
which is
the bookkeeping method used by most businesses, regardless of their size, nature, or structure.
This
bookkeeping method assures that the balance sheet statement always equals in the end. In essence,
the
accounting equation is as follows:

Assets (A) = Liabilities (L) + Owner's Equity (OE)

A= L+OE
L=A-O E
OE= A- L

Assets = Liabili ties + Equity

Cash
Inventory
Rec eovablea A c count• Payable
Prepaid E xpenses Owner Contributions + Rell9nuea +
Note s Poyable Owner W ithdrawals •
Equipment D e ferred Revenue
Sales Woges
Interest Cost of Goods Sold
Rental Income Rent
Servic e Fees Depree iabon
Advertiaing
Pro,.a a ional Fees
Ublitiea
Office Supplies

Accounti ng Elements In the Accounti ng Equation

,. Assets. These are resources controlled by an entity as a result of past events and from which
future
economic benefits are expected to flow to the entity. (conceptual Framework for Financial Reporting)
2. Liabilities . These are the obligation of the entity arising from past events, the settlemen t of which
is
expected to result in an outflow from the entity resources embodyin g economic benefits.
(conceptual
Framework for Financial Reporting)
 3. CapitaUEquity. This is the residual interest in the assets of the entity after deducting all liabilities.
( Conceptual Framework for Financial Reporting)

Resources = Claims
Claims of Creditors (L~~~.Oities)
-··
Resources (Assets)= +

Claims of Owners (Equity/Capital

4. Withdrawal/Drawing. The process usually involves the removal of an asset from an entity's
operations. In other words, its money the owner took out of the company to use for personal expenses.
5. Revenue. It refers to a specific type of income. It is the value of all goods and services generated by
a company.
6. Expenses. It refers to the money spent and the costs incurred by a company in pursuing revenue.
Simply put, account expenses are the costs involved in running a business, and collectively they
contribute to the activities involved in generating profit.

Effects of Different transactions to the Accounting Elements in the Accounting Equation

For the accounting equation to work, the effect on both sides needs to always be equal, so you
should always expect the changes to be parallel unless two or more accounts of the same side of the equation
are affected.
h .
1. Transactions That Affect Assets and Liabilities

Type of Transaction Effects on Accounting Equation

Purchase of inventory on credit, 1 Increase Assets, Increase Liabilities
Getting a loan from the bank Increase Assets, Increase Liabilities
Repayment of a liability Decrease Assets, Decrease Liabilities

2. Transactions that Affect Assets and Owner's Equity

Type of Transaction Effects on Accounting Equation

Capital contribution by the owners Increase Assets, Increase Equity
Payment of dividends to shareholders Decrease Assets, Decrease Equity
Owner drawings Decrease Assets, Decrease Equity
Depreciation of assets Decrease Assets, Decrease Equity
Write-off a bad debt Decrease Assets, Decrease Equity
Sales revenue Increase Assets, Increase Equity

3. Transactions that Affect Liabilities and Owner's Equity

Type of Transaction Effects on Accounting Equation

Interest payable on a loan Increase Liabilities. Decrease Equity
Converting a loan liability into equity Decrease Liabilities, Increase Equity
Accrued expenses Increase Liabilities, Decrease Equity

4. Transactions that Do Not Affect the Accounting Equation

Type of Transaction Effects on Accounting Equation

 None
Purchase of a current and fixed asset
for cash
None
Transferr ing funds from one bank

,
account to another one owned by the
same business
None
Collection of Accounts
Typical Account Titles Used
Statemen t of Financial Position (Balance Sheet)

ASSETS are classified into two: current assets and non-curre nt assets
An account is classified into current asset if:
cycle;
1. they are expected to realize an asset, intends to sell or consume in ts normal operating
2. holds the asset permanently;
3. it expect to realize the asset within twelve months after the reporting period; and
from
4. the asset is cash or cash equivalen t (as defined in PAS No. 7) unless the asset is restricted
being exchange d or used to settle a liability for at least twelve months after the reporting period.

Current Assets ( -II-IOI\ CO.I\ b 4 con\/(,f~fd t-o c~h ,,.,/ ;.., C/1 !1eor 1
coins,
1. Cash is any medium of exchange that a bank will accept for deposit at face value. It includes
currency , checks, money orders, bank deposits and drafts.
to known
2. Cash Equivalents are short-term highly liquid investments that are readily convertible
amounts of cash and which are subject to an insignificant risk of change of value (PAS No. 7)
of money
3. Notes Receivable is a written pledge that a customer will pay the business a fixed amount
on a certain date.
goods on
4. Accounts Receivables are claims against customers arising from sale of services or
credit/account.
process for
5. Inventories are assets which are held for sale in the ordinary course of business; in the
production of such sale; and in the form of materials or supplies to be consume d in the productio n
process or in the rendering of services (PAS No. 2).
pens, tapes,
6. Supplies /Supplies Inventory /Supplies on Hand are bond paper, paper clips, fliers, ball
paste, and the like not yet used by the business.
in advance
7. Prepaid Expenses are expenses already paid but not yet incurred or expenses paid for
by the business (prepaid rent, prepaid advertising , prepaid insurance , prepaid interest) .

e that is
8. Allowance for Bad Debts is contra asset account. It is a portion of the accounts receivabl
estimated to be uncollectible.

Non-Current Assets/Fixed Assets/ Property Plant & Equipme nt

use in the
1. Property, Plant and Equipment are tangible assets that are held by enterprise for the
and
production or supply of goods or services, or for rentals to others, or for administr ative purposes
which are expected to be used for more than one period (PAS No. 16). This includes:

1.1 Land - piece of lot owned by the business

1.2 Building - building owned by the business
1.3 Machinery & Equipment - used in the processing raw materials
1.4 Store & Office Equipment - used in store and office
1.5 Furniture & Fixture - tables, chairs, and the like
1.6 Vehicles
 2. Accumulated Depreciation is a contra asset account that contains the sum of the periodic
depreciation charges. The balance of this account is deducted from the cost of the related asset to
obtain the book value of the asset.

3. Intangible Assets are identifiable non-monetary without physical substance held for the use in the
production or supply of goods or services for rentals to others or for administrative purposes (PAS
No. 38). ~- Pc,,\el\l, cop_,n~t, ..II(;\ tvt,.cltn,Qrl<,)

LIABILITIES are classified into two: current liabilities and non-current liabilities
1. Are expected to settle the liability in its normal operation;
2. It holds the liability for the purpose of trading;
3. The liability is due to be settled within twelve months after the reporting period; or
4. The entity does not have an unconditional right to defer settlement of the liability for at least twelve
months after the reporting period .

All other liabilities are classified as non-current liabilities.

Current Liabilities

1. Notes Payable - obligation of the business to outsider that is supported by a promissory note.
2. Accounts Payable - obligation of the business to outsider not supported by a promissory note.
3. Accrued Liabilities - amount owed to other for unpaid expenses (interest payable, salary payable,
utilities payable, taxes payable and etc.)
5. Unearned Revenues - collection of amount for income not yet earned (unearned rent income).
6 . Current Portion of Long-Term Liabilities - are portion of mortgage notes, bonds and other long-
term indebtedness which are to be paid within one year from the statement of financial position.

Non-Current Liabilities
1. Mortgage Payable - obligation of the business to outsider that is secured by a pledge of certain asset
as security to the creditor.
2. Bonds Payable - money borrowed to finance the acquisition of needed assets.

OWNER'S EQUITY
1. Capital is used to record the original and additional investment of the owner of the business entity. It
is increased by the amount of profit earned and decrease by the amount of loss.
2. Withdrawal - is used when to owner withdraw cash or other asset to the business.
3. Income Summary - is a temporary account which is use to close nominal accounts (income and
expense accounts) .

Statement of Financial Performnace (Income Statements)

INCOME
1. Service Income - is used to record income earned in rendering services.
2. Sales - is used to record sale of merchandise or goods.
3. Interest Income - is an income earned out of lending money or goods to the outsider.
4. Rent Income - is an income earned out of renting portion of the space to outsider.
EXPENSE d to customers
cos t inc urr ed to pur cha se or to produce the products sol
Cost of Goods Sold - is the
1.
during the period the services
is an am oun t pai d to all pay ment made to employees for
se -
Salaries and Wages Ex pen
2_
entity.
they rendered to the business light and wa ter.
ht & Po we r/U tili ty Ex pe ns e - payment of the use of
3. Electricity/Heat, Lig
e or mobile).
Ex pen ses - pay me nt of the use of telephone (landlin
4. Telephone
ets rentals
the use of space or oth er ass
5. Rent Expense - payment for
nt of insurance coverage.
6. Insurance Expense - payme , radio, and
nt for adv erti sin g the bus iness (billboards, streamers
me
7. Advertising Expense - pay
television)
the like.
of bondpaper, fliers, tapes, and
8. Supplies Expense - use
asset due to its used.
allocation of the cost of fixed
9. Depreciation Expense -
be collected.
Exp ens es - por tion of acc ounts receivable that cannot
10. Bad Debts
the business.
ere st Ex pen se - pay ment of interest for loans made by
11 . Int

Review Questions
letter of you r Choice.
1- Multiple Choice: Encircle the
ct is an increase in
yees for their services, the effe
1. When an entity pays emplo j
c. liabilities d. income
ra.
'--'
expenses b. assets
except
l
has all of the following effects
2. Withdrawal by the proprietor
a. reduction of total asset c. reduction of cash balance
ome for the period
I
b. reduction of owner's equity ( <:!- reduction of net inc

iture and fixture for cash

3. When an entity acquires furn
increased
a. assets and owner's equity
ile another decreased
~b. one asset is increased wh
a liability is decreased
c. an asset is increased and
ile another is also increased
d. one asset is increased wh
except
tor has all the following effects
4. Withdrawals by the proprie
c. reduction of owner's equity
a. reduction of total assets iod
d. reduction of net income for the per
b. reduction of cash balance
e
g account exceeds net incom
5. When an amount of drawin
c. capital increases
a. capital decreases
d. all of the above
b. no effect in capital
the
equation A -- L + C ' w hen assets decreases and liabilities remain
6. Based on the accounting
same

a. capital decreases c. capital increase

b. no effe ct in capital d. none of these
7 · An account can have a credit balance when
side of the account
a. all e~tries are on the credit
it totals
b. credit totals exceeds deb ls
dit tota
c. debit totals exceeds cre
d. all of the se
 ess?
a. What represents the claims of the creditor over the assets of the busin
a. asse ts b. liabilities c. capital d. all of these
the
being depe nded upon the rights confe rred upon
9. Asse ts having no physical nature, their value
owne r by their possession
c. intan gible s d. inves tmen ts
a. fixed asse ts b. curre nt asse ts
ies to empl oyee s?
10. Wha t happ ens when a busin ess pays salar
t
a. incre ase in asse t; decre ase in anot her asse
b. decre ase in asse t; decre ase in prop rietor ship
c. incre ase in asse t decre ase in liability
d. none of these

wing on the space provided.

11 - Indicate the appropriate account title for the follo
faste ners, carb on pape r, etc.
1. Cost of stationeries, coup on bonds, pencil,
-- -- -- -- -
- - - - - - - - - 2. Pliers, wrench, hamm
ers, jack and the like.
l prom ise to pay the busin ess.
_ _ _ _ _ _ _ _ _ 3. An oral or verba and etc.
ines, typew riters , comp uters , cash regis ters,
_ _ _ _ _ _ _ _ _4. Calculators, adding mach evide nce by a
ess from a custo mer or clien t as
__ _, __ _ _ _ _ 5. Amo unt collectible by the busin
promissory note.
by an acco untan t or CPA in publi c pract ice.
_ _ _ _ _ _ _ _ _ 6. An incom e earned
ay cases, cabin ets, etc.
_ _ _ _ _ _ _ _ _ 7. Chairs, tables, displ orted
ctible by the supp lier to the busin ess whic h is not supp
_ _ _ _ _ _ _ _ _ 8. Is an amou nt colle
by a promissory note. gove rnme nt
registration fees and the like impo sed as
_ _ _ _ _ _ _ _ _ 9. Business permits,
regulations to operate a business. custo mers .
d by the business used to deliver good s sold to
_ _ _ _ _ _ _ _ _ 10. A motor vehicle owne
r's equit y.
following transactions to asset, liability and owne
II - On the space provided, write the effect of the
answer.
Write increase, decrease, or no effect as your
Owner's
I Transaction
I Asse t Liabilities Eauitv
1Boug ht supplies on account.
2 Invested cash and supplies to the
Business.
3 Rendered services to custo mer on acco unt
4 Collected cash from custo mer for servi ces
rendered on account.
5 Bought refrigerator in cash to be used in
the owne r's home .
6 Boug ht car on acco unt for personal use.
7 Returned to the supp lier supp lies boug ht on
account.
8 Paid rent for the mont h
9 Paid salaries of empl oyee s
10 Made partial pavm ent to su oolie r

Problems:

I - Answer the following question:

800,0 00. How much is the owne r's equit y?
has liabilities of
I . A company has a_ss~~~ of P1 ,500,000 and
al of P400 ,000. How much is the assets?
2. D company has hab1ht1es of P1 ,000,000 and capit
al of P2, 100,000. How much is the liabilities?
3. Z company has assets of P3,000,000 and capit
4. Complete the table :
 Assets Liabilities Capital
P300,000 ?
1
2
PB00,000
? P1,600,0 00 P2,400 ,000 1
PS,000,000 ? P3,458,0 00
3
P6,400,0 00 P2, 867,000 ?
4
? 746,000 P984,350
5

month, the firm

11 _ Durning Ajax is the owner and operator of the Surf Breeze Laundry Services. During the
completed the following transactions:

1. Ajax invested P10,000 in the business.

2. Purchase P200 laundry supplies for cash.
3. Bought P3,000 worth of new washing machine on account
4. Received PS00 from customer for laundry services.
5. Paid the wages of labander as P450.
6. Sold some laundry supplies at cost PSS.
7. Billed customer for laundry services rendered on account P675.
8. Collected PS2S from some customer s who paid their account on time.
9. Paid the Tide Repair Shop for repairs made to a damaged washing machine P380.
10. Ajax withdrew PS00 from the firm for payment of his children's tuition fees

titles: cash ;
Required: Entered the above transactions in the accounting equation using the following account
Ajax drawing;
accounts receivable; laundry supplies; laundry equipment; accounts payable; Ajax capital;
laundry service income; wages expense; and repair expense.

A s s E T sLIABILITIES Owner's Equity

1
=

Cash
f' lliPOO
Accounts
Receivable
Laundry
Supplies
Laundry
+
Accounts
Equipment Payable
Owner's
Equity
p ,o,ooo
Account Title
4jeu< /
1
C-Qri'lal
'
1
2 ( -zoo) ~ 200)

3 ~ ) 3,~() ?, 1 001:) ....

4 €~
.Soti ~ Se.-.ice lr1<--0ni<

5 (<.!~)
(~)
6 65 { 55"

7 · c..lr c,=ts
8
9
10

Ramos for the

Ill - Presented below are the transactions of the Double Realty Company, owned by Roy- - ·
month of March 2003 . -
1. The owner invested P10,000 cash
2. Paid P1 ,800 as the rent for March of an office building .
3. Paid 300 as the rent for March on an automobile.
4. Paid P200 for office supplies received.
5
· Earned COl'J:'lmission of P15,000 on real estate transactions. No cash received on this date.
6. Collected p12,o~o cash from clients on account.
7 · Re~ived a bill f~r P300 for advertising in the local paper in March .
 a. Paid cash for gas and oil consumed in March P425. j ~ w\- ,, 0 ,
9. Paid PB,000 to employees for services provided in March. ~~ .J · Ol'

10. The owner withdrew P500 cash. j 1 1 c•'

• l

Required: 1. Record the above transaction using a financial state~ent worksheet. Use the accounting
equation to answer the problem. 2. State the effects of these transaction to the assets, liabilities and capital
of the business.

IV • Summary financial data of Buenas Enterprises, a service business, for November are presented in the
following equation. Each line designate by a letter indicates effect of a transaction on the equation. Only
transactions (d), (f), (g) and (h) affect revenue and expenses.

1. Describe each tr~nsaIction.

2. What is the amount of the increase in cash for the month?
3. What is the amount of the net income for the month?
4. How much of the net income was retained in the business?

Accumulated Accounts Capital/Owner's

Cash + Supplies+ Equipment - Depreciation = Payable + Equity
1 2,000 3,000 8,000 (2,000) 1,000 10,000
2 (200) (200)
3 300 300
4 2,600 (2,600)
5 100
6 (800) (BOO)
7 (600) (600)
8 (100) (100)
9 (500) (500)

V - From the following information, state the impact of the transactions to the assets, liabilities and capital of
the business

Transaction Impact of Transaction Assets Liabilities Capital

1 Increase in one asset balance by a decrease in
another asset
2 Increase in asset balance by an increase in liability
3 Decrease in asset balance by a decrease in liability
4 Increase in liability by a decrease in another liability
5 Increase in asset balance by an increase in capital
6 Decrease in asset balance by a decrease in capital

VI - On the space provided , write the effect o9f the following transactions to asset, liability and owner's equity. W-ite
increase, decrease, or no effect as your answer.

-
Transactions Assets Liabilities Owner's Equity
1 Bought supplies on account
2 Invested cash and supplies to the business
3 Rendered services to custo,mer on account
4 '
Collected cash from customer for s ervicesrendered
on account
5 Bought refrigerator in cash to be used in the owner's f(

home
6 Bought car on account for personal use
 ,,
'7 Returned to the supplier supplies bought on account L
' _]
Paid rent for the month , i. ...
8
9 Paid salaries of employees I t ..
lilt;, '
~
f"f.(_
r PU
10 Made partial payment to supplier C

'
('