MODULE 2

THE ACCOUNTING EQUATION

A. The Basic Accounting Equation

ASSET = LIABILITIES + EQUITY

Assets – are the economic resources owned by the business. They are
economic resources that the business controls which resulted from past events
and can provide it with economic benefits. These are what the company
“own”.

Liabilities – present obligations that have resulted from past events and can
require the business to give up economic resources when settling them. These
are what the company “owed”.

Equity – simply assets minus liabilities. Other terms for equity are “capital”, “net
assets”, and “net worth”.

Summary of transactions and their effects on the accounting elements

OWNER'S
TRANSACTIONS ASSETS = LIABILITIES + EQUITY
Investment of assets by the owner Increase Increase
Withdrawal of assets by the owner Decrease Decrease
Additional Investment by the owner Increase Increase
Increase &
Purchase of assets in cash Decrease
Purchase of assets on account Increase Increase
Settlement of liabilities in cash Decrease Decrease
Increase &
Settlement of account with a note Decrease
Settlement of liabilities from owner's
personal cash Decrease Increase
Revenue earned (on account or cash) Increase Increase
Expenses incurred Increase Decrease
Payment of expenses Decrease Decrease

B. The Expanded Accounting Equation

Assets = Liabilities + Equity + Income – Expenses

Income – represents increases in economic benefits during the period in the

form of increases in assets, or decreases in liabilities, that result in increases in
equity, excluding those relating to investments by the business owner.

Prepared by: ATTY. JUDY MAR F. VALDEZ, CPA

 Expenses – represent decreases in economic benefits during the period in the
form of decreases in assets, or increases in liabilities, that result in decreases in
equity, excluding those relating to distributions to the business owner.

Note: The difference between income and expenses represents profit or loss.
• If income is greater than expenses, the difference is profit.
• If income is less than expenses, the difference is loss.

Hence, another variation to the equation above is as follows:

Assets = Liabilities + Equity _ Profit/Loss

Note: Profit increases equity while loss decreases equity.

*Note that owner’s equity is consist IPAWE

Initial Investment
+/- Profit/(Loss)
+ Additional Investment
- Withdrawal
= Ending Capital

C. The Accounts

Account – the basic storage of information in accounting. It is a record of the

increases and decreases in a specific item of asset, liability, equity, income or
expense.

The Five Major Accounts

The five major accounts, also called the elements of the financial statements,
are actually the items in the expanded accounting equation.

1. Assets -
2. Liabilities
3. Equity
4. Income
a. Revenue – arises in the course of ordinary activities of a business, e.g.
sales and service fees.
b. Gains – represent other items that meet the definition of income and
may or may not arise in the course of the ordinary activities of an entity.

5. Expenses
a. Expenses – arise in the ordinary activities of a business.

Prepared by: ATTY. JUDY MAR F. VALDEZ, CPA

 b. Loss – represent other items that meet the definition of expenses and
may or may not arise in the course of ordinary activities of the entity.

Note:
• If the selling price is greater than carrying amount, the difference is
a gain.
• If the selling price is less than carrying amount, the difference is loss.

Classification of the Five Major Accounts

BALANCE SHEET ACCOUNTS INCOME STATEMENT ACCOUNTS

Assets Income
Liabilities Expenses
Equity

• The balance sheet (statement of financial position) is one of the components

of a complete set of financial statements. The balance sheet shows the
financial position of a business.

• The income statement (statement of financial performance/statement of profit

or loss) shows the summary of income and expenses and the profit or loss of a
business.

Chart of Accounts – a list of all the accounts used by a business.

The following is an example of a basic chart of accounts.

100 Assets 400 Revenues

110 Cash 410 Sales
111 Accounts Receivable 411 Sales Returns and Allowances
112 Notes Receivable 412 Sales discount
113 Interest Receivable 500 Costs and Expenses
115 Merchandize Inventory 510 Cost of goods sold
116 Office Supplies 520 Sales salaries expense
117 Prepaid Insurance 521 Advertising expense
120 Land 522 Depreciation expense – store
equipment
123 Store Equipment 529 Miscellaneous selling expense
124 Accumulated depreciation – 530 Office salaries expense
store equipment
125 Office Equipment 531 Rent Expense
126 Accumulated depreciation- 532 Depreciation expense – office
Office Equipment equipment
200 Liabilities 533 Insurance expense
210 Accounts Payable 534 Office supplies expense

Prepared by: ATTY. JUDY MAR F. VALDEZ, CPA

211 Salaries Payable 539 Miscellaneous administrative
expense
212 Unearned rent 600 Other Income
215 Notes payable 610 Rent income
300 Owner’s Equity 611 Interest Income
310 Capital 700 Other expenses
311 Drawing 710 Interest Expense
312 Income Summary

EXERCISES

I. TRUE OR FALSE

1. Total Assets are P100,000.00. Total liabilities are P60,000.00. Therefore, total
equity is P40,000.00.
2. Total assets are P20,000.00. Total liabilities are P16,000.00. Therefore, total
equity is P36,000.00.
3. Total assets are P80,000.00. Total equity is P60,000.00. Therefore, total
liabilities are P20,000.00.
4. Total liabilities are P60,000.00. Total equity is P30,000.00 is P30,000.00.
Therefore, total assets are P30,000.00.
5. Total income is P100,000.00. Total expenses are P40,000.00. Therefore, the
difference of P60,000.00 is profit.
6. Total income is P50,000.00. Total expenses are P60,000. Therefore, the
difference of P10,000.00 is loss.
7. Beginning equity is P100,000.00. profit during the period is P20,000.00. if
there are no other changes in equity, the ending balance of equity must
be P120,000.00.
8. Beginning equity is P10,000.00. Loss during the period is P4,000.00. If there
are no other changes in equity, the ending balance of equity must be
P6,000.00.
9. Total assets are P100,000.00. total liabilities are P40,000.00. total equity
before income and expenses are P40,000.00. therefore, profit is P20,000.00.
10. Total assets are P100,000.00. Total liabilities are P60,000.00. Total equity,
before income and expenses is P30,000.00. If total income is P50,000.00,
total expenses must be P30,000.00.

II. Using the accounting equation, compute the missing financial statement
amounts:

OWNER'S
COMPANY ASSETS = LIABILITIES + EQUITY

A 300,000.00 25,000.00

B 450,000.00 350,000.00

Prepared by: ATTY. JUDY MAR F. VALDEZ, CPA

 C 900,000.00 250,000.00

D 500,000.00 2/5
E 20% or 800,000
F 780,000.00 290,000.00
G 990,000.00 270,000.00
H 890,000.00 170,000.00
I 1,420,000.00 360,000.00
J 1920,000.00 890,000.00

III. a. Total assets of Red River Co. amounts to P 2,550,000 and the owner has
a 60% interest over it. How much is its liabilities? ________________
b. Total liabilities of Danielle Company amounts to P 40,000 which is 40% of the
total assets. How much is the owner’s equity? _______________
c. Total liabilities amounts to P 500,000. Total owner’s equity is thrice the
liabilities. How much is the total assets? _______________
d. Total assets at the beginning of the year is P 1,000,000 and the liabilities is P
400,000. During the year, the assets increased by P 500,000 but liabilities
increased only half as much as the assets increased. How much is the owner’s
equity at the end of the year? ________________

IV. A list of transaction appears below. Indicate which accounting elements of

the business are affected by placing in the respective columns the amounts
and the + (Increase) or – (decrease) sign or NA, if the element is not
affected. Ariel is the owner manager of You do note Computer shop.

OWNER'S
TRANSACTIONS ASSETS = LIABILITIES + EQUITY
a) Ariel retired and received P 2,000,000
pension. He contributed half of this to
put up a Computer shop business.
b) From the remaining pension, he
bought a car, for his own use.
c) He hired a cashier for a monthly
salary of P 7,500 a month.
d) He bought 10 computer sets from Da
best on credit. Each set is priced at P
30,000.
e) He bought tables and chairs and
paid a total of P 200,000.
f) He paid half of the account due to
Da Best.
g) He took home P 50,000 cash for his
own use.

Prepared by: ATTY. JUDY MAR F. VALDEZ, CPA

h) Ariel charges P 15 pesos per hour. For
the whole month, total customer
consumotion is 600 hours. All customers
paid in cash as Ariel has a no credit
policy.
i) Total billing for utilities amounted to P
25,000.
j) Paid the utilities.
k) Ariel made an additional cash
investment of P 100,000.
l) Paid the monthly salary of cashier.

V. Compute the missing amounts.

ASSETS = LIABILITIES EQUITY + INCOME - EXPENSES

+
1 590,000.00 380,000.00 130,000.00 210,000.00
2 490,000.00 280,000.00 40,000.00 180,000.00
3 860,000.00 220,000.00 360,000.00 80,000.00
4 360,000.00 90,000.00 180,000.00 70,000.00
5 410,000.00 170,000.00 480,000.00 190,000.00
6 920,000.00 710,000.00 290,000.00 440,000.00
7 870,000.00 310,000.00 240,000.00 150,000.00
8 890,000.00 240,000.00 600,000.00 190,000.00
9 740,000.00 170,000.00 1,900,000.00 1,860,000.00
10 780,000.00 470,000.00 680,000.00 490,000.00

VI. Complete the statement of financial position of Mr. Orange and prepare
the capital statement. He started the Wash Ur Car Business three months
ago with a capital of P 50,000.
Assets Liabilities and Owner’s Equity
Cash P 7,000 Accounts Payable P14,000
Accounts Receivable ? Notes Payable ?
Car ? Orange, Capital ?
Equipment ?

Determine the missing figures based on the following information and give the
total assets, total liabilities and owner’s equity:
a. Record shows that customers owe the firm P 40,000
b. The car costs P 180,000 but its current trade in value is only P 100,000.
c. Mr. Orange signed a note payable to the bank for P 300,000 which he used
to buy the car and equipment. But he says he has already paid half of this
note.

Prepared by: ATTY. JUDY MAR F. VALDEZ, CPA

Reference:

Cruz-Manuel, Zenaida Vera. International Edition 2012. 21st Century Accounting

Process (Basic Concepts and Procedures). Raintree Trading & Publishing, Inc.

Millan, Zeus Vernon B. 2023. Financial Accounting & Reporting (Fundamentals).

Nation’s Foremost CPA Review Inc.

Balla, Win and Ballada Susan. 2021. Basic Financial Accounting and Reporting (Made
Easy). DomDane Publishers & Made Easy Books.

Prepared by: ATTY. JUDY MAR F. VALDEZ, CPA