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Fundamentals of Accountancy,
Business and Management 1
Third Quarter – Module 3

THE ACCOUNTING
EQUATION
MELC: Illustrate the accounting equation and perform operations involving
simple cases with the use of accounting equation.

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PART 1: INTRODUCTION

Accounting is extremely important for recording the financial transactions in a business.

Without accounting, you cannot display the financial health of your business to your stakeholders.
Accounting is pivotal for various aspects and plays a crucial role in preparing the compiled financial
statements. Businesses spend a great amount of time and money in recording their financial
transactions. However, are these painstaking efforts finally worth it? Let’s explore what accounting
equation has to play in businesses.

DISCUSSION OF CONCEPTS

➢ WHAT IS ACCOUTING EQUATION?

Accounting equation is a basic principle of accounting and a fundamental element of the

balance sheet. It is considered to be the foundation of the double-entry accounting system.

From the large, multi-national companies down to the corner small business, every business
transaction will have an effect on a company's financial position. The financial position of a company
is measured by the following items:

▪ Assets (what it owns)

▪ Liabilities (what it owes to others)

▪ Owner's Equity (the difference between assets and liabilities)

These are the building blocks of the basic accounting equation. The accounting equation is:

ASSETS = LIABILITIES + EQUITY (OWNER’S EQUITY)

For Example:

A sole proprietorship business owes P300, 000 and you, the owner personally invested P500,
000 of your own cash into the business. The assets owned by the business will then be
calculated as:
P300, 000.00 (what it owes) + P500, 000.00 (what you invested) = P700, 000.00 (what the company has in
assets)

Assets = Liabilities + Owner’s Equity

P700, 000 P300, 000 P500, 000

In a sole-proprietorship, equity is actually Owner’s Equity. If the business in

question is a corporation, equity will be held by stockholders, which uses stockholder’s
equity but the basic equation is the same:
 ASSETS = LIABILITIES + EQUITY (STOCKHOLDER’S EQUITY)

For Example:

A business owes P850, 000 and stockholders (investors) have invested P1, 100, 000 by buying
stock in the company. The assets owned by the business will then be calculated as:
P850, 000 (what it owes) + P1, 100, 000 (what stockholders invested) = P1, 950, 000 (what the company has in assets)

Assets = Liabilities + Stockholder’s Equity

P1, 950, 000 P850, 000 P1, 100, 000

➢ DEFINITION OF AN ACCOUNT AND CHART OF ACCOUNTS

Account is a descriptive storage unit used to collect and store information of similar nature.
The accounting equation “assets equal liabilities plus equity” perfectly captures the major
accounts. These major accounts which also happen to be the main classification of accounts, are
assets, liabilities, equity. Owner’s equity includes revenues and expenses. An account is an
individual accounting record of the movements (increases and decreases) in specific accounts.

Chart of Accounts is a listing of all the accounts and is usually tailored to the operations
of the business. It functions as a guide to the accountant or the bookkeeper in ensuring uniformity
of and consistency in the use of all the accounts in recording business transactions.

➢ MAJOR ACCOUNTS (ASSETS, LIABILITIES AND EQUITY)

▪ ASSETS

✓ Resources owned or controlled by a company.

✓ Anything tangible or intangible that can be owned or controlled to produce value

and that is held by a company to produce positive economic value.

✓ CURRENT ASSETS

Any asset which can reasonably be expected to be sold, consumed, or exhausted

through the normal operations of a business within the current fiscal year or
operating cycle.

Example:

1. Cash - cash on hand, cash deposited in bank, cash fund.

2. Receivables – Accounts Receivable (receivable from customers), Notes

Receivable (receivables supported by promissory notes), Rent
 Receivable, Interest Receivable, Due from Employees (or
Advances to Employees), and other claims Inventories

3. Inventories - assets held for sale in the ordinary course of business.

4. Unused Supplies – represents supplies which remain unused.

5. Prepaid expenses – expenses paid in advance, such as, Prepaid Rent,

Prepaid Insurance, Prepaid Advertising, and Office
Supplies

✓ 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 than 12 months or the company's normal
operating cycle.

Example:

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.

▪ LIABILITIES

✓ What a company owes to its creditors in future payments, products, or services.

✓ Payable—means a liability that promises a future outflow of resources.

✓ CURRENT LIABILITIES are debts that must be repaid in less than 12 months.

Examples: bank overdraft, creditors.

 ✓ NON CURRENT LIABILITIES are debts that take longer than 12 months to
repay.

Examples: Mortgage and other long term loans.

✓ Examples of Liability Accounts

Accounts Payable – this refers to open accounts which represents the

amount of money owed by the business to creditors or suppliers.

Notes Payable – this represents the amount of money owed by the business
to the supplier or creditor evidenced by a promissory note.

Loan Payable – this represents the amount of money borrowed by the

business from third party creditors.

Mortgage Payable – this represents the amount of money borrowed by the

business from a bank or a lending institution which is secured by collateral.

Unearned Revenues - this represents cash collected by the business in

advance for a service or good that is yet to be rendered or delivered.

▪ EQUITY

✓ Is the owner’s claim on assets.

✓ It is the owner’s actual interest in the business.

✓ Also called “net assets” or “residual equity”.

✓ Can be found by subtracting total assets from total liabilities.

✓ Revenues - increase in company resources from the sale of goods or services.

Examples: consulting services provided, sales of products, facilities rented

to others, commissions from services.

✓ Expense - costs encountered in the normal course of business.

Examples: costs of employee time, use of supplies, advertising from others,

utilities from others

✓ Net Income - an overall measure of performance for the period which equals
revenues less expenses.

In other situation, we encounter The Expanded Accounting Equation by including two more
elements – income and expenses. The expanded accounting equation shows all the financial statement
elements. The expanded accounting equation is as follows:

Assets = Liabilities + Equity + Income - Expenses

 Notice that income is added while expenses are deducted in the equation because income
increases equity while expenses decrease equity.

Income – are increases in economic benefits during the period in the form of inflows or
enhancements of assets or decreases of liabilities that result in increases in equity, other than those
relating to investments by the business owners.

While, Expenses – are decreases in economic benefits during the period in the form of outflows
or depletions of assets or increases of liabilities that result in decreases in equity, other than those
relating to distributions to the businessowners.
In addition, the difference between income and expenses represents profits or loss.

➢ If income is greater than expenses, the difference is profit (“profit” means “kita” or “tubo” in
Filipino)
➢ If income is less than expenses, the difference is loss (“loss” means “lugi” in Filipino)

We can make another variation to the equation above as follows:

Assets = Liabilities + Equity + Profit/Loss

Note: profit increases equity while loss decreases equity

Illustration:
During the period, you earned income of P10, 000 and incurred expenses of P6, 200.
At the end of the period, your total assets increased from ₱2,000 to ₱5,000 and your total
liabilities decreased from P1, 200 to P400.
Your expanded accounting equation is as follows:

Assets = Liabilities + Equity + Income - Expenses

5,000 400 800* 10,000 6,200

* This represent your equity from “Illustration1”.

We can also derive the following variation from the equation below:

Assets + Expenses - Liabilities + Equity - Income

5,000 6,200 800* 10,000 6,200

Your profit for the period is P3, 800 (P10, 000 income minus P6, 200 expenses). There is profit
because income is greater than expenses.

A Variation of the expanded accounting equation is shown below.

Assets = Liabilities + Equity + Profit

5,000 = 400 + 500 + 3,800

 Income expenses (or profit or loss) are closed to equity at the end of each accounting period.
Thus, the adjusted ending balances of equity is computed as follows:

Equity, beginning 800

Add: Income 10,000
Less Expenses (6,200)
Equity, ending 4,600

or

Equity, beginning 800

Add: Profit 3,800
Equity, ending 4,600

Your basic accounting equation as of the end of the accounting period is as follows:

Assets = Liabilities + Equity

5,000 = 400 + 4,6000

Notice that regardless of the form or variation, the accounting equation (basic or expanded) remains
balance.
 PART 2: ACTIVITIES
Activity I: TYPE OF ACCOUNTS

DIRECTIONS: Identify and arrange the following items from Table 1 to Table 2
with appropriate type of accounts (Assets, Liabilities, or Owner’s Equity).

Table 1
Prepaid rent Cash Maria, Capital Maria, Drawing
Mortgage payable Unearned Revenues Building Net worth of the business
Unused supplies Loan Payable Assets minus Service Income
Owner’s Equity

Table 2
Assets Liabilities Owner’s Equity

Activity II: ACCOUNTING MATCH

DIRECTIONS: On the space provided, write the letter that corresponds to each of the
given statements.

a. Account Receivables
b. Owner’s Equity
c. Cash
d. Accounting Equation
e. Freight- Out
f. Professional fees
g. Assets
h. Salary Expense

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 1. coins and bills in the possession of the business
2. right of the owner in the business
3. delivery expense for merchandise sold
4. assets equal liabilities and owner’s equity
5. properties of the business, tangible or intangible
6. amount paid for service of employees
7. income derived in the practice of profession
8. collectible from clients for services rendered on account

PART 3. FORMATIVE ASSESSMENT

WRITTEN OUTPUT
1. MULTIPLE CHOICE
DIRECTIONS: Choose the letter corresponding to the correct answer for each of the questions provided
below.
1. An agreement to receive service fee from the customers requires debit to
a. an asset c. capital
b. a liability d. expense
2. It is refers to the descriptive storage unit used to collect and store information of similar nature.
a. account c. chart of accounts
b. accounting equation d. cash
3. It is refers to open accounts which represents the amount of money owed by the business to
creditors or suppliers.
a. accounts payable c. mortgage payable
b. loan payable d. notes payable
4. Equity means assets minus liabilities. Other terms that can be used synonymously with equity
are the following except
a. Capital c. Net worth
b. Net assets d. Profit

5. Sources of legal obligation are the following except

a. The law b. Debts
c. Contract d. Other operation by law

2. CASE ANALYSIS

1. If Lakay Lugawan has total assets of ₱115,000 and total liabilities of ₱12,500, how much is Lakay
Lugawan total equity?

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2. Hanna Maganda has total assets of P25, 000 and equity of P32, 000, how much is her liabilities?

3. The total income of Basit Machine Shop is P110, 000 and total expenses of P30,000, how much is Basit
Machine Shop profit (or loss)?

3. DETERMINATION OF ASSETS, LIABILITIES AND EQUITY. (2points)

The initial investment of the owner in his business is P75,000. At the end of each year, the total

assets of the business amounted to P100,000, which consists of P50,000 cash and ₱50,000 equipment.

The equipment has an unpaid balance of ₱20,000, the only liability of the business. How much is the

owner’s equity at the end of the year?

Solutions: