Topic 3: ACCOUNTING EQUATION

2.1 Accounting Equation

Business transactions affect the assets, liabilities and equity of the business. These
effects can be expressed as:

ASSETS = LIABILITIES + EQUITY

The formula above implies that a business, being a separate economic entity from its
owner, generally acquires economic resources (assets) which are contributed by its
creditors (liabilities) and owners (equity).

2.2 Effects of Transactions on Accounting Equation

Double Entry Bookkeeping – recognizes the two-fold effect on the accounting elements
by recording the values received on the left side (debit) and the value parted with on the
right side (credit).

Principle of Debit and Credit – means that every business transaction can be measured

in monetary terms by recording such transactions using a system of debit and credit.
Debit means left side of an account while Credit means right side of an account.

Account – is an accounting device that summarizes the effects of business transactions

(increases or decreases) in the accounting elements. Also known as “account title”.

Chart of Accounts – is a masterlist of all account titles. It serves as a guide in

determining which particular account to use when recording business transactions. A
sample for a sole proprietorship engaged in service business is shown below:

Assets Income
Cash Service Income
Accounts Receivable
Office Furniture & Fixtures Expenses
Office Equipment Salaries Expense
Rent Expense
Liabilities Office Supplies Expense
Utilities Payable Repairs & Maintenance Expense
Loans Payable Light & Water Expense
Communication Expense
Owner’s Equity Taxes & Licenses Expense
Owner’s Capital Travel & Transportation Expense
Owner’s Drawing Miscellaneous Expense

Rules of Debit and Credit:

1. Debit to increase an asset, or an expense; and to decrease a liability, equity, or

income.
2. Credit to decrease an asset, or an expense; and to increase a liability, equity, or
income.

Normal Balances of Accounts:

Debit Credit
Asset
Liability
 Equity
Income
Expense

Analysis of Transactions:

Always remember that each transaction affects two accounts. Answering the following
questions is helpful in analyzing the business transactions:

1. Is there an accounting transaction?

2. What are the accounts affected?
3. What are the effects of the transaction on the accounts?
4. What is the appropriate account to describe the effects of the transaction?
5. How much is the amount to be recorded for a particular account?

Illustration of Transaction Analysis:

Transaction 1 – Mr. Johnfrivs started his sole proprietorship business by investing

P200,000 cash.

Transaction 2 – The business purchased office equipment for P80,000 by paying cash.

Transaction 3 – The business borrowed P70,000 cash from a local bank.

Transaction 4 – The business billed its client P60,000 for services rendered.

Transaction 5 – The business paid its employees for salaries of P20,000.

Transaction 6 – The business made partial collections of P30,000 from its billing from
clients.

Transaction 7 – The business received its electric bill of P10,000 for the current month
payable next month.