Unit 3

Analyzing Business Transactions

The Accounting Equation

Accounting as a whole is based on a single equation:

ASSETS = EQUITY + LIABILITIES

The word equation comes from the word equal.

For any equation, one side always equals another. Also, equations can be made out of anything.

For example:
1 Orange = $0,50
House = Walls + Doors + Windows + Roof
1 week = 7 days

Assets = Liabilities + Equity

When the total amount of liabilities is added to the total amount of capital/equity, the sum
should be equal to the total assets of the business.

In preparing reports, if the sum of both the liabilities and capital will not equal to the
amount of assets, then it is easy to say that something went wrong along the process.

Since there are three (3) elements involved in the equation, you can simply modify the
original formula to derive the values of the other elements. It is shown below:

Liabilities = Assets - Capital and Capital = Assets - Liabilities

To make things more understandable, let us assign values to the coefficients:

Let A: assets where A = ?
L: liabilities L = 7,000
C: capital/equity C = 3,000

Therefore:
A = L + C
*10,000 = 7,000 + 3,000

If you try to have the derivation for Liabilities, it can be done this way:
L = A - C
7,000 = 10,000 - 3,000

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 If you try to have the derivation for Capital, it can be done this way:
C = A - L
3,000 = 10,000 - 7,000

***Assuming we decrease our total assets by ₱1,000 making it only ₱9,000 in total and
assuming the same level of liability, there should be a DECREASE of ₱1,000 in the capital
section making it only ₱2,000. It is shown below:
A = L + C
9,000 = 7,000 + * 2,000

***Assuming we increase our total assets by ₱1,000 making it ₱11,000 in total and
assuming the same level of liability, there should be an INCREASE of ₱1,000 in the capital
section making it ₱4,000. It is shown below:

A = L + C
11,000 = 7,000 + * 4,000

Account Titles
Account titles are unique terms given to accounts in a system of accounting. These
terms/names assigned are used by accountants in recording transactions.

The following are account titles for the different elements of financial statements:

A. Assets
➢ Cash -- This title represents money, checks, money orders, and bank drafts
used by the entity. It may be “cash on hand” or “cash in bank” depending on
where it is placed.
➢ Accounts Receivable -- This is the title used to refer to accounts arising from
the liability of your customers when you sell goods to them or when you
rendered services for which they haven’t paid yet.
➢ Notes Receivable -- This is somehow similar to accounts receivable except
that there is a promissory note that serves as an evidence of the customers’
indebtedness.

➢ Supplies -- Title used for items such as stationeries, clips, rubber bands, ink,
and the like.

➢ Merchandise Inventory – This is used to record items that are held for sale
in the “ordinary course” of business. Not all items that are for sale will be
classified under Merchandise Inventory account. If an item is held for sale
BUT is not normally being sold, that item IS NOT part of merchandise
inventory.
As an example, assume that you are operating a store selling school supplies.
The things that you sell in the “ordinary course of business” are the school
supplies, and therefore are part of your Merchandise Inventories.
Continuing the example, if you hold your mini electric fan from your store for
sale, that electric fan CANNOT be labelled as Merchandise Inventory since
the selling of that item is not aligned with your usual or ordinary course of
business.
➢ Prepaid expenses -- These are items that the business entity pays in
advance. It could be in the form of prepaid insurance, prepaid rent, etc.

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 This becomes an asset since you can still use it in the future. Just because
there is the word “expense” doesn’t mean that it is an expense.
B. Liabilities
➢ Accounts Payable -- This is the opposite of accounts receivable and is being
used to record items that you owe to your suppliers or when you avail
services that the business has not paid yet.
➢ Notes Payable -- This arises when you owe from your suppliers and there
is a promissory note as an evidence of the transaction. This is the opposite of
Notes Receivable.

C. Capital
➢ Owner’s Capital -- This is normally written bearing the name of the owner
like “Jerome, Capital”.

➢ Owner’s Drawing -- Used when the owner pulls out his investment from
the business. This is written like “Jerome, Drawing”

D. Income
➢ Service Income/ Service revenue -- This account title is used for the income
earned from the rendering of services.
➢ Sales Revenue -- This is an income account used for income earned from
selling goods/items in the ordinary course of business.

E. Expenses
➢ Salaries expense -- Used to record the salaries of employees
➢ Utilities expense -- Used for recording water, electricity, telephone,
internet bills and the like.
➢ Repairs and maintenance -- Account title used in recording repair works
availed.
➢ Interest expense -- Used for recording any interest that has accrued in
relation to your debts.
**There are a lot more account titles to be used and you’ll get to know more of them as
you go to higher accounting subjects.

Normal Balances of Accounts

The term “normal balance” refers to the side where the account is normally being found.
There are only two sides used in accounting: DEBIT and CREDIT.

Debit is derived from the Latin term “debere” which means “value received” and credit is
derived from the Latin term “credere” which means “value parted with”. You will learn
more about debit and credit on the next unit.

Assets, Expenses and Withdrawals (Drawing Account) have normal DEBIT balance. This
means that they are normally found on the LEFT side.

Liabilities, Capital (Equity), and Income have normal CREDIT balance. This means that they
are normally found on the RIGHT side.

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Illustrative Problem:

For each transaction, analyze the effects to the elements such as Assets, Liabilities, and
Capital. After analyzing, indicate whether there is an INCREASE, DECREASE or NO EFFECT at
all to the 3 elements. Below are the transactions of Mireio Motor Servicing.

1/3 The owner invested money amounting as initial capital for his business.

A = L + C
Increase = No Effect + Increase

Note that the owner invested money which is actually an asset (cash). Since the
money flowed into the business, it now becomes the asset of the business causing an
increase in the asset section. Furthermore, remember that investments cause the
capital section to increase.

There is no effect in the liability section since the entity did not incur any obligation
after the owner invested his money.

1/12 The owner pulled out a portion of his cash investment from his business.

A = L + C
Decrease = No Effect + Decrease

This is what we call a “withdrawal” by the owner. Since CASH has been withdrawn/
pulled out from the business, there is a DECREASE in the asset section. Because of
the withdrawal, the owner’s capital will DECREASE. (recall the factors affecting
capital from the previous unit)

No liability is involved in pulling out the investment from the company so it is

labelled with “NO EFFECT”.

1/13 In the name of the business, a new machine was acquired for the store that is being
operated. Said purchase was paid, ₱35,000.

A = L + C
No Effect = No Effect + No effect

There’s an INCREASE in asset in the form of a machine (machinery) because the

business purchased it. However, there is also a DECREASE in asset because of the
outflow of cash for the payment. The asset increased and decreased at the same
time. With this, we could say that there is NO EFFECT in total in the asset section.

Since the machine was already paid, there should be NO EFFECT in the liabilities
section as there was no liability incurred.

Observe that the left side of the equation (assets) has NO EFFECT. In an equation,
the left and right side must always be equal or balanced.

So, if the left side is not affected, right side must not be affected as well. Since the
liabilities section is not affected, it follows that the capital section must have NO
EFFECT as well to make the left and right side equal.

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1/14 The business acquired a computer set to be used in the office. The purchase was made
on account/on credit.

A = L + C
Increase = Increase + No effect

A computer set is classified as an asset (office equipment) since it can provide

future benefits to the business. With its acquisition, there should be an INCREASE in
the asset section.

The phrase “on account” or “on credit” means that there is NO payment involved
yet. Because of this, an obligation to pay on the part of the buyer arises. And so, the
liability section will INCREASE. The liability is called “accounts payable”

Notice that the asset section on the left and the liability section on the right both
have increased. This makes the equation already balanced. With this, the capital
section must have NO EFFECT. (remember the factors that can increase or decrease
the capital from the previous unit)

1/15 Supplies were bought on account.

A = L + C
Increase = Increase + No effect

Supplies will become part of assets because it can be used in the future. After buying
it, assets will increase. Since the supplies were acquired on account, there will be an
increase in the liability section in the name of accounts payable.

1/23 Refer to the transaction from January 14. This time, assume that the business paid for
the computer set that was purchased on credit/ on account.

A = L + C
Decrease = Decrease + No effect

What do you think will happen if you pay for your liability?

The answer is simple. Your CASH, which happens to be an ASSET, will DECREASE
because you used it to pay for your liability. On the other hand, since the ACCOUNTS
PAYABLE has been paid, the liability section shall DECREASE.

After considering the asset and liability sections, you can see that the left and right
side of the equation are already in balance. With that, the CAPITAL section must
have NO EFFECT. After all, nothing from the transaction has affected the capital
account.

1/24 Services were rendered to clients but they haven’t paid yet (without promissory note).
See the answer below.

A = L + C
Increase = No Effect + Increase

Recall the accrual basis assumption and the revenue recognition principle.
When services are already rendered, an income is already earned even if there is no
payment received yet. The income is called “Service revenue/ service income”.
Income will cause the capital section to INCREASE. (recall the factors affecting the
capital from the previous unit)

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 On the other hand, since your clients did not pay you yet, you will have an “accounts
receivable” which is an ASSET. This will INCREASE the asset section. Nothing
happened to your liabilities since you only rendered services. In fact, it is your
clients who have a liability.

If there is a promissory note involved, use “notes receivable”.

1/27 In relation to the transaction from January 24, assume that the clients paid. Here is the
analysis:

A = L + C
No effect = No Effect + No effect

This is a simple collection of payment from your clients. Your “accounts

receivable” will now DECREASE because you already received payment. On the
other hand, your “cash” will INCREASE. Both of them are assets having opposite
effects. OVERALL, there is NO EFFECT in the asset section.

Liabilities are not affected because there was only a collection of customer accounts.

1/28 The business received the electricity bill and payment has been made immediately.

A = L + C
Decrease = No Effect + Decrease

The most obvious account that is affected is “cash” because it is the one used for
payment. With that, the asset section will DECREASE.

Electricity bills will fall under “utilities expense”. Since there is an expense, capital
will DECREASE. (recall the factors affecting the capital from the previous unit)

1/30 The business paid for an insurance premium in advance.

A = L + C
No Effect = No Effect + No Effect

Note that the word used is “paid”. It is obvious that “cash” will decrease. The thing
that was paid for is insurance and this is actually an asset because this can be used
in the future. With the existence of this insurance, asset section will INCREASE. It is
called “prepaid insurance”.

In this case the accounts affected are both from the asset section but with opposite
effects. Overall, there would be NO EFFECT in the total assets.

1/31 For business use, the business owner borrowed money from the bank.

A = L + C
Increase = Increase + No Effect

Since the money borrowed was for the business, such money will go to the company.
Therefore, assets will INCREASE in the form of “cash”.

On the other hand, the act of borrowing money from the bank will result in an
INCREASE in liability/obligation. The liability is called “loans payable”.

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 Below is a table showing the different factors and their corresponding effect to the
capital section:

Factors affecting capital Effect on Capital

Investments Increase
Withdrawals Decrease
Income Increase
Expenses & losses Decrease

The table below shows the distribution of accounts as to their normal balances:

Debit (dr) Credit (cr)

Expenses Owner’s equity/ capital

Assets Income
Drawings/ withdrawals Liabilities

Reference:

HBL Module by Chavez & Malquisto

********** Nothing Follows**********

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