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The Accounting Equation

An accounting equation shows the relationship between assets and equities.
Assets are properties owned or controlled by the business. Rights or claims against the
assets are called equities. The relationship between assets and equities can be presented
in this equation:

ASSETS = EQUITIES

Equities are divided into two (2) types: The equity of creditors called liabilities,
and the equity of the owner called capital or owner’s equity. To give recognition to the
two basic types of equities, the accounting equation is express as:

ASSETS = LIABILITIES + OWNER’S EQUITY

Owner’s equity or capital is the excess of total assets over total liabilities.
Creditor’s claim has priority over claims of the owner, thus owner’s equity is considered
residual. To give emphasis to the residual claim of the owner or owners, the accounting
equation may be expressed as follows:

ASSETS - LIABILITIES = OWNER’S EQUITY

Transactions and Their Effects on the Accounting Equation

Business transactions or events may result to changes in the values of the basic
elements of the accounting equation. The effects are summarized below:

1. Increase in assets accompanied by an increase in owner’s equity such as:

a. Original investment and additional investment by the owner
b. Receipt of income
2. Increase in assets accompanied by increase in liabilities.
3. Decrease in assets because of a decrease in liabilities.
4. Decrease in asset because of a decrease in owner’s equity due to:
a. Withdrawal of the owner
b. Expenses paid or incurred
5. Increase in one asset with a corresponding decrease in another asset account.

Business Transactions and Changes in the Fundamental Accounting Equation

Business Transaction
Business transactions are events which involve the exchange of values between
two or more parties. Alternatively, business transactions are economic events that occur
in the business causing at least two changes in accounts. These are always expressed in
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terms of money. They should be entered in the accounting records and recognized as
affecting the accounting equation. These transactions are analysed from the various
business documents such as official receipts, sales invoice, payroll, vouchers, promissory
notes, contracts, checks, bills, register tapes, etc.

Double –Entry Accounting

Double-entry accounting is a universally accepted accounting system of
recording business transactions where at least two (double) accounts are affected and the
equality of the accounting equation is maintained.
The following are the steps involved to analyse transactions:
1. From the business document, determine the kind of transaction or exchange made.
2. Analyze the transaction to determine the accounts affected. They can either affect
the assets, liabilities, owner’s equity, revenue or expenses accounts.
3. Determine the effect of the transaction on the accounts affected. The transaction
can either increase or decrease the accounts.
4. Apply the rules of debit and credit to identify whether the accounts affected
should be debited or credited to show the corresponding increase or decrease.

The Theory of Debit and Credit

A theory to facilitate the recording of the effects of transactions on the accounting
equation has been develop. This is the theory of debit and credit.
An account is an accounting device used in summarizing the changes in the
assets, liabilities, revenue and expenses due to the occurrence of business transactions.
The simplest form of the account is the T-account. It got its name from its structure
which is similar to letter T. It is presented below:

Title of the Account

Left Side Right Side

or or
Debit Side Credit Side

The T-account has three (3) parts

1. Title of the account
2. Space on the left side called the debit side
3. Space on the right side called the credit side
The amounts entered on the left side of the account is called debits or charges
while the amounts placed on the right side of the accounts are called credits.
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The left side of the equation contains the assets while the right side contains the
liabilities and owner’s equity. This show that assets are normally on the debit side while
liabilities and owner’s equity are normally on the credit side. This would lead to another
basic equation as follows:
Debits = Credits

When a transaction occurs, it is recorded by debiting the value received and

crediting the value parted with. The value received is a debit while the value parted with
is a credit.
Value received (Debit) = Value parted with (Credit)

A minimum of two (2) accounts are affected in every business transaction and the
sum of the debits is always equal to the sum of the credits. This method is known as
double-entry accounting system.

Debit and Credit Account

Assets represent value controlled or owned by the enterprise. As assets acquired,
values are received, thus further debits. Decreases in assets mean values are given out,
thus credits.
Liabilities are obligations to pay. These are values of promises given out, thus
the account is credited. When a liability is paid, the value of the promise given out is
reduced or reacquired, thus the account is debited.
Owner’s equity represents the right given by the business, thus a credit.
Whenever the owner invests some more, there are further credits to the account. If the
owner withdraws assets for personal use, the capital or owner’s equity is reduced. But
instead of debiting directly to the capital account, the drawing account is debited.
Income or revenue are increases in the owner’s equity as a result of business
operations. Income represents services or goods given out, thus a credit.
Expenses are decreases in owner’s equity as a result of profit directed activities of
the enterprise. They simply services received, thus debits.

The rules of debits and credits and the normal balances of the various
accounts are summarized below:

Account Normal Balance Debit Credit

Assets Debit Increase Decrease
Liability Credit Decrease Increase
Owner’s Equity or
Credit Decrease Increase
Capital
Drawing Debit Increase Decrease
Income Credit Decrease Increase
Expenses Debit Increase Decrease
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The rules of debit and credit are shown below using T-accounts:

Assets Liabilities
Debit Credit Debit
Credit

Increase Decrease
Decrease Increase

Drawing Owner’s Equity or

Capital
Debit Credit Debit Credit

Increase Decrease Decrease Increase

Expenses Income
Debit Credit Debit Credit

Increase Decrease Decrease Increase

Normal Balance of an Account

The normal balance of an account is the increase side of an account. Normal

balance is the usual balance of an account. For instance, cash being an asset is debited
when increased. Therefore, the normal balance of a cash account is debit.
Note: Business transaction are analysed on the viewpoint of the business. If the
purchasing officer purchase equipment, it is actually the business that is purchasing the
equipment. Thus, record the transaction as a debit to equipment and a credit to cash.

Exercise No. 1
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A computer house owned and operated by Ms. Katrina Lorie just started operation
and its main service is the renting out of computer facilities on a time-slot basis. In its
first month of operation for the year 2020, the following selected transactions took place.

January 2 Invested P500,000.00 as a start up capital.

January 4 Received cash borrowed from Phil. National Bank, P500,000.00.
January 4 Purchase office supplies for use in the shop, P10,000.00.
January 5 Paid rent in advance for one year, P60,000.00.
January 7 Purchased 15 units computer, P300,000.00.
January 12 Bought tables and chairs for shop use from Fine Furnishing on account,
P20,000.00.
January 14 Received cash from clients, P25,000.00.
January 15 Paid salary of two shop aides, P6,000.00.
January 17 Sent a bill to Twilight Trading for computer services rendered P15,000.00.
January 18 Ms. Lorie withdrew P2,000.00 cash for personal use.
January 20 Paid the account with Fine Furnishing.
January 22 Received a check from Twilight Trading as settlement of its account.
January 30 Received a bill from CAPELCO, P10,000.00.
January 30 Ms. Lorie made additional investment, P100,000.00.
Instruction. Show the effect of the above business transactions in the accounting
equation

Exercise No. 2
Listed below are business transactions of Corona Company during its first month
of operation:

March 3 Mr. Corona invested cash in the business amounting to P300,000.00.

March 5 Purchased equipment for cash, P50,000.00.
March 10 Purchased inventory through credit, P30,000.00.
March 15 Purchased furniture worth P50,000.00. Made partial payment in cash
P20,000.00 and incurred an accounts payable for the balance.
March 17 Paid cash to the local government for business permit P5,000.00
March 20 Made sales of P20,000.00, P10,000.00 cash sales, and the balance on
credit.
March 22 Paid inventory purchased on March 10.
March 25 Paid the accounts payable on March 15.
March 28 Collected credit sales on March 20.
March 31 Paid employee P10,000.00.
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Instruction: Indicate the effects of the given transaction above on each of the
accounting elements in the table shown below.

DATE Assets Liabilities Equity Revenues Expenses

Total
= +

Exercise No. 3

The following are transactions for NIC Art Gallery for the month of September,
2019.

September 1 Nic Ong invested P500,000.00 in the business.

September 1 Acquired delivery truck to be used in the business, P300,000.00.
September 1 Rented office space and paid two months rent in advance, P30,000.00.
September 2 Nic Ong issued a promissory note for a P200,000.00 loan from Metro
Bank. The notes carried a 12% interest per annum. The interest and the
principal are payable after one year.
September 2 Hired an office secretary with P5,000.00 monthly salary. The secretary
started work on the same day.
September 2 Called SM Art Supplies and ordered oil paints and brushes worth
P12,000.00
September 4 Paid Insular Life Insurance Co. P20,000.oo for one year insurance of the
art gallery.
September 5 Acquired office equipment from Abensons P50,000.00, paying P20,000.00
and the balance at the end of the month.
September 8 The 12,000.00 oil paints ordered from SM Art Supplies were delivered on
account.
September 10 Paid SM Art Supplies of the amount owed.
September 11 Painted the portrait of Monalisa receiving P200,000.00 cash for the
completed portrait.
September 15 Paid secretary’s salary for half month, P2,500.00.
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September 17 Received P250,000.00 cash contract to paint the portrait of President

Duterte.
September 21 Delivered and billed Mr. Sy P150,000.00 for a landscape painting.
September 23 Nic Ong withdrew P30,000.00 for personal use.
September 23 Received bill from PLDT, P1,000.00
September 25 Received P100,000.00 from Mr. Sy as partial payment for landscape
painting delivered last September 21.
September 30 Paid electricity bill for the month, P4,000.00.
Instruction: Indicate the effects of the given transaction above on each of the
accounting elements in the table shown below.

Date Assets = Liabilities and Owner’s Equity

=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
=
Total =
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Summative
Assessment

I. True or False. Write true if the statement is true, otherwise write false before the
number.

______________ 1. Current assets less current liabilities equals equity.

______________ 2. A business activity is accountable once it has an effect on assets,
liabilities or capital.
______________ 3. A decrease in asset may result to a decrease in another form of asset.
______________ 4. An increase in liabilities may cause an increase in assets.
______________ 5. All increases to expense and asset accounts are debits.
______________ 6. The normal balance of assets, expenses and equity accounts is
credits.
______________ 7. Debits means increases while credit means decreases.
______________ 8. The simplest form of an account is a T-account.
______________ 9. An increase in revenue may be accompanied by an increase in
assets.
______________10. Claims of creditors and owners should equal to the assets.

II. Problem Solving I. Compute the assets, liabilities and Equity. Place the final
answers on the spaces provided on the left side of the numbers.

__________________ 1. AJ Enterprise’s assets amount to P3,465,000. The equity of the

owner is P2,150,000. How much is the equity of the creditors?
__________________ 2. EMS Repair Shop has assets amounting to P455,000. EMS
capital is P125,500. How much is the total liability?
__________________ 3. Total investment of Mr. Wong to Wong Laundry Shop is
P867,900. Total debt of the business is P357,895. How
much is the total assets?
__________________ 4. OX Café income for the month is P785,435. It spent P866,500
for operation. How much is the net loss for the month?
__________________ 5. A business has total assets of P3,345,000. If 60% represents
equity of creditor, how much is the equity of the
owner?

Problem Solving II. Debits and Credits. Analyze the transaction and post in the T-
accounts.
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Heart Love put up a HL Computer Shop with an investment of P200,000.

1. Paid P10,000 for 5 months rent of shop space.
2. Purchase computer worth P30,000. Issued a note.
3. Receives P50,000 from clients for services rendered.
4. Paid the supplier of computer, 50% of the note.
5. Paid salaries of employees P15.000.