FABM 1 Lesson 7 The Accounting Equation

FUNDAMENTALS OF ACCOUNTANCY, BUSINESS, AND MANAGEMENT
Lesson 7: The Accounting Equation
The basic accounting equation, also called the balance sheet equation, represents the relationship
between the assets, liabilities, and owner’s equity of a business. It is the foundation for the double-entry
bookkeeping system. For each transaction, the total debits equal the total credits.
From the large, multi-national corporation down to the corner beauty salon, every business transaction will
have an effect on a company’s financial position. The financial position of a company is measured by the following:
1. ASSETS are tangible and intangible items of value which the business owns. Examples are:
 Cash
 Land
 Buildings
 Debtors (money owed from customers)
 Stock / Inventory
 Accounts Receivable
 Prepaid Insurance
 Investments
 Equipment
 Goodwill
2. LIABILITIES are those items which are owed by the business to bodies outside of the business. Examples
include:
 Notes or Loans Payable
 Accounts Payable
 Salaries and Wages Payable
 Interest Payable
 Short-term Borrowings
 Long-term Debt
 Creditors (money owed to suppliers)
 Bank Overdrafts
3. OWNER’S EQUITY or STOCKHOLDER’S EQUITY is the amount left over after liabilities are deducted from
assets:
𝐎𝐰𝐧𝐞𝐫′ 𝐬 (𝐨𝐫 𝐒𝐭𝐨𝐜𝐤𝐡𝐨𝐥𝐝𝐞𝐫′ 𝐬) 𝐄𝐪𝐮𝐢𝐭𝐲 = 𝐀𝐬𝐬𝐞𝐭𝐬 − 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬
If a company keeps accurate records, the accounting equation will always be "in balance", meaning the left
side should always equal the right side. The balance is maintained because every business transaction affects at least
two of a company's accounts.
For example, when a company borrows money from a bank, the company's assets will increase and its
liabilities will increase by the same amount. When a company purchases inventory for cash, one asset will increase
and one asset will decrease. Because there are two or more accounts affected by every transaction, the accounting
system is referred to as double-entry accounting.
A company keeps track of all of its transactions by recording them in accounts in the company's general
ledger. Each account in the general ledger is designated as to its type: asset, liability, owner's equity, revenue,
expense, gain, or loss account.
General Ledger is that part of accounting system which contains the balance sheet and income statement
accounts used for recording transactions.
BALANCE SHEET AND INCOME STATEMENT

The Balance Sheet is also known as the “Statement of Financial Position” and it reflects the accounting
equation. The balance sheet reports a company's assets, liabilities, and owner's (or stockholders') equity at a specific
point in time. Like the accounting equation, it shows that a company's total amount of assets equals the total amount
of liabilities plus owner's (or stockholders') equity.
The Income Statement is the financial statement that reports a company's revenues and expenses and the
resulting net income. While the balance sheet is concerned with one point in time, the income statement covers
a time interval or period of time. The income statement reports the revenues, gains, expenses, losses, net income,
and other totals for the period of time shown in the heading of the statement.
Assets Invested By The Owner
July 1 – Paolo Reyes started a delivery service on July 1, 2013. The following transactions occurred during
the month of July. He invested PHP800, 000 cash and cars amounting to PHP200, 000.
ASSETS = LIABILITIES + OWNER’S EQUITY

Cash PHP800, 000 (No Effect) Reyes, Capital PHP1, 000, 000
Cars PHP200, 000
Borrowings From The Bank
July 2 – Reyes borrowed PHP100, 000 cash from PNB for use in his business.

Cash PHP900, 000 Loans Payable PHP100, 000 Reyes, Capital PHP1, 000, 000
Cars PHP200, 000
Asset Purchased For Cash
July 7 – Bought tables and chairs from Orocan and paid PHP45, 000 cash.

Cars PHP200, 000
Furniture PHP45, 000
Assets Purchased On Account
July 15 – Various equipment were purchased on account from Fortune for PHP55, 000.

Cars PHP200, 000 Accounts Payable PHP55, 000
Equipment PHP55, 000
Cash Withdrawal By The Owner
July 18 – Reyes made a cash withdrawal of PHP5, 000 for personal use.

Cars PHP200, 000 Accounts Payable PHP55, 000 Reyes, Drawing (PHP5, 000)
Payment Of Liability
July 20 – The account due to Fortune was paid in cash.

Cars PHP200, 000 Reyes, Drawing (PHP5, 000)
The following table summarizes the effects of these transactions on the accounting equation:
Date ASSETS LIABILITIES OWNER’S EQUITY
Loans Accounts Reyes, Reyes,

July Cash Cars Furniture Equipment
Payable Payable Drawings Capital
1 800,000
200,000 100,000 1,000,000
2 100,000
Balances 900,000
200,000 45,000 100,000 1,000,000
7 (45,000)
Balances
855,000 200,000 45,000 55,000 100,000 55,000 1,000,000
15
Balances 855,000
200,000 45,000 55,000 100,000 55,000 (5,000) 1,000,000
18 (5,000)
Balances 850,000 55,000

200,000 45,000 55,000 100,000 (5,000) 1,000,000
20 (55,000) (55,000)
Balances 795,000 200,000 45,000 55,000 100,000 0 (5,000) 1,000,000
1,095,000 1,095,000
Determining Profit through Operation

 Accrual basis of accounting VS Cash basis of accounting – accrual basis recognizes revenue when earned
and recognizes expenses when incurred.
 Under the expense recognition principles, expenses can be recognized either as: (1) matching; (2)
systematic allocation, or; (3) direct association.
 Profit measures the performance of the company. If the revenue exceeds expenses, then it is a net profit;
otherwise, it is a net loss.
DOUBLE-ENTRY ACCOUNTING
Double-entry accounting is a system where every transaction affects both sides of the accounting
equation. For every change to an asset account, there must be an equal change to a related liability or shareholder’s
equity account. It is important to keep the accounting equation in mind when performing journal entries.
Journal entries are the building blocks of accounting; from reporting to auditing journal entries (which
consists of Debits and Credits). Without proper journal entries, companies’ financial statements would be inaccurate
and a complete mess.
The balance sheet is broken down into three major sections and their various underlying items: ASSETS,
LIABILITIES, and OWNER’S / SHAREHOLDER’S EQUITY.
Total Liabilities
Current Liabilities + Non-Current Liabilities
Total Assets
Current Assets + Non-Current Assets
Total Owner’s / Shareholder’s Equity
Share Capital + Retained Earnings
Below are some examples of items that fall under each section:
i. Assets:
 CASH (Current Assets)
 Current assets are all assets that can be reasonably converted to cash within one year. They
are commonly used to measure the liquidity of a company.
 ACCOUNTS RECEIVABLE
 A current asset account that keeps track of money that third parties owe to you. These third
parties can be banks, companies, or even people who borrowed money from you.
 A common example of accounts receivable is interest receivable that individuals usually
get from making investments or putting money into an interest-bearing savings account.
 INVENTORY
 A current asset found on the balance sheet, consisting of all raw materials, work-in-
progress, and finished goods that a company has accumulated.
 It is often deemed the most illiquid of all current assets; thus, it is excluded from the
numerator in the quick ratio calculation.
 EQUIPMENT (Property, Plant and Equipment / PP&E)

 One of the core non-current assets found in the balance sheet. PP&E is impacted by Capital
Expenditures (CapEx), Depreciation, and Acquisitions/ Dispositions of fixed assets.
 These assets play a key part in the financial planning and analysis of a company’s
operations and future expenditures.
ii. Liabilities:
 ACCOUNTS PAYABLE
 A current liability account that keeps track of money that you owe to any third party. The
third parties can be banks, companies, or even someone who you borrowed money from.
 One common example is mortgage payable. When you take out a mortgage, you sign a
contract that states that you will pay the loan back over a period of time in installments.
 Accounts Payable is considered one of the most liquid forms of current liabilities.
 SHORT-TERM BORROWINGS
 Current liabilities are financial obligations of a business entity that are due and payable
within a year.
 A liability occurs when a company has undergone a transaction that has generated an
expectation for a future outflow of cash or other economic resources.
 LONG-TERM DEBT
 LTD is any amount of outstanding debt a company holds that has a maturity of 12 months
or longer. It is classified as a non-current liability on the company’s balance sheet.
 The time to maturity for LTD can range anywhere from 12 months to 30+ years and the
types of debt can include bonds and mortgages.
iii. Owner’s / Shareholder’s Equity:

 SHARE CAPITAL
 Shareholder’s capital/ equity capital/ contributed capital/ paid-in capital
 The amount invested by a company’s shareholders for use in the business. When a company
is created, is its only asset is the cash invested by the shareholders, then the balance sheet is
balanced through share capital.
 RETAINED EARNINGS
 The retained earnings formula represents all accumulated net income netted by all
dividends paid to shareholders.
 Retained Earnings are part of equity on the balance sheet and represent the portion of the
business’s profits that are not distributed as dividends to shareholders but instead are
reserved for reinvestment.
SAMPLE PROBLEM
Transaction 1
After making cupcakes in your Grandma’s kitchen your whole life, you decide to open a bakery. You use your
$10,000 in savings to start your business.
Accounts Affected: You have just put $10,000 into the bank, which is an asset. This goes on the debit side.
Now that the debit side has gone up, we need to balance this with $10,000 on our credit side. We know that our
$10,000 investment represents an increase in owner’s equity, and owner’s equity will go on the credit side. With
these two entries, the equation is now balanced.
Debit Credit
Bank +$10,000 Owner’s Equity +$10,000
Transaction 2
You need an iPhone to take delivery calls from all your crazy customers. You buy one off eBay for $500.
Accounts Affected: Our bank account, an asset, is going to decrease. Now that we know the Debit side has
decreased, we need to record the second side of the transaction that will keep the equation in balance. We’re going to
create a new asset account called iPhone, because we need to record the new phone as an asset. Remember, it cost
$500, so the two sides of the transaction are:
Debit Credit
Bank -$500
iPhone +$500
Our bank caused the debit side to decrease, but then our new phone caused it to increase. That means our
debit side had no change in the end, and our equation still balances.
Why didn’t the credit side change in this example like it did in the previous example? Remember, the credit
side is only involved in transactions that relate to liabilities and owner’s equity. In this particular transaction, only
assets were involved: we used an asset (bank) to purchase another asset (iPhone).
We saw above that owner’s equity only relates to investments made personally by the owner. In this
example, we used the business bank account to purchase a business asset. Therefore the owner was not involved. If
we had used the owner’s personal bank account to buy the iPhone, then our owner’s equity on the credit side
would have increased.
Transaction 3
It’s time to go oven shopping, but first, you need some cash. You visit Anne, the loan officer, and she gives
you a loan of $10,000.
Debit Credit
Account Amount Account Amount
Bank $10,000 Loan $10,000
Transaction 4
It’s your lucky day. You just won a lottery prize of $5,000. You decide to invest your $5,000 into the business.
Debit Credit
Bank $5,000 Owner’s Equity $5,000
Transaction 5
We don’t want Anne to get angry. You better pay back some of the loans. You decide to pay back $1,000.
Debit Credit
Bank -$10,000 Loan -$10,000
Transaction 6
You need a computer to start taking internet orders and also to watch funny Youtube videos after work. You
purchase a computer for $1,500.
Debit Credit
Bank -$1,500
Computer $1,500
Transaction 7
Your oven was stolen! Time to purchase the new Bakemaster X Series! It costs you $2,000.
Debit Credit
Bank -$2,000
Oven $2,000
After recording these seven transactions, our accounts now look like this. We have all our assets listed on
the debit side and all our liabilities and owner’s equity listed on the credit side.
DEBIT CREDIT
Bank $20,000 Loan $9,000
Computer $1,500
Oven $2,000 Owner’s Equity $15,000
iPhone $500
$24,000 $24,000
REMEMBER
(DC DEA-LER)
DEBIT CREDIT
Draw (Withdrawals) Liabilities
Expenses Equity
Assets Revenue
THE T-ACCOUNT
The effect of changes in Assets, Liabilities, and Owner’s Equity are being summarized in an accounting
device called Account. This device will group these accounting values with their amounts belonging to one item only.
In the item cash for example, all amounts representing increases and decreases in cash are entered in the account
“cash”.
An account is divided into two sides. The left-hand side which is called the “debit side” and the right-hand
side which is called the “credit side”.
The left-hand side or debit shows the value received while the right-hand or credit side shows the value
parted with of transaction analysis. The device is commonly called T-Account because it resembles a capital letter
“T”. An account title is written above the T-Account.
Example:
ACCOUNT TITLE
Left-Hand Side Right-Hand Side
or or
Debit Side Credit Side
is for is for
VALUE RECEIVED VALUE PARTED WITH
An amount entered on the left-hand side of the account is called a Debit Entry while the amount entered on
the right-hand side is called a Credit Entry.
The moment an account is assigned to an item to which a title has already been designated, such account
becomes identical to the item thereafter. For instance, the account assigned to the item “Cash” becomes known as
“Cash Account”; the account assigned to the item “Notes Receivable” becomes known as “Notes Receivable Account”;
the account assigned to the item “Rent Expense” becomes known as “Rent Expense Account”; and so forth.
To illustrate: Shown below is a T-Account for the item Cash:
CASH
Dr. Cr.
P25,000 P10,000
The words Debit and Credit came from the Latin words “debere” and “credere”. The former is abbreviated
as “Dr.” and “Cr.”
The words Debit and Credit can be used either as a Verb or as an Adjective:
a) As a Verb:
 “To Debit” means to enter the amount of value received on the debit side of an account.
 “To Credit” means to enter the amount of the value parted with on the credit side.
 We then say,
i. “Cash account was debited by P25,000.”
ii. “Cash account was credited by P10,000.”
b) As an Adjective:
 The words Debit and Credit are used to describe the two sides of the account.
 We then say,
i. “The debit side of cash account has an entry of P25,000.”
ii. “The credit side of cash account has an entry of P10,000.”
The total of the debit amounts or debit entries of an account is called debit total while the total of the credit
amounts or credit entries of an account is called credit total.
Let’s assume, “cash account” has the following entries:
CASH
Dr. Cr.
P25,000 P10,000
20,000 5,000
Debit Total P45,000 P15,000 Credit Total

SIDE POSITIONING
Additions and subtractions in the recording process are done by Side Positioning. An account has two
sides: the debit side and the credit side. An Asset which has a normal balance of a debit is increased by entering
the amounts on the debit side and is decreased by entering the amount on the credit side.
Liabilities and Owner’s Equity which have the normal balances of credit are increased by entering the
amounts on the credit side and are decreased by entering the amounts on the debit side.
The other way of viewing these situations is by using the terms “Positive” and “Negative”; Positive means
Add and Negative means Deduct. The normal balances of these values and its temporary accounts are stated as
Positive.
To illustrate:
ASSETS
DEBIT SIDE CREDIT SIDE

Normal Balance or
Negative Side
Positive Side (Deductions or Decreases
(Additions or Increases are
are entered here)
entered here)
We then say: Debit to INCREASE an Asset and Credit to DECREASE an Asset.
LIABILITIES

Normal Balance or
Negative Side
(Deductions or Decreases
Positive Side
are entered here)
entered here)
We then say: Credit to INCREASE a Liability and Debit to DECREASE a Liability.
OWNER’S EQUITY

Normal Balance or
Negative Side
Positive Side
are entered here)
entered here)
We then say: Credit to INCREASE an Owner’s Equity and Debit to DECREASE an Owner’s Equity.
The increases and decreases of an Owner’s Equity account are diagrammed below:
INCREASE DECREASE
Investments by Withdrawals by
owner Owner
OWNER'S
EQUITY
Revenues Expenses
TEMPORARY ACCOUNTS
Drawing or Personal – the reduction of an Owner’s Equity account arising from cash or property
withdrawal of an owner is not debited to Owner’s Equity account to effect the decrease but instead debited
to “Drawing Account”.
DRAWING OR PERSONAL

Normal Balance or
Negative Side
are entered here)
entered here)
We then say: Debit to INCREASE a Drawing and Credit to DECREASE a Drawing.
Income – all income earned of the same nature are summarized in this account.
INCOME

Normal Balance or
Negative Side
Positive Side
are entered here)
entered here)
We then say: Credit to INCREASE an Income and Debit to DECREASE an Income.
Expenses – all expenses incurred of the same nature are summarized in this account.
EXPENSES

Normal Balance or
Negative Side
are entered here)
entered here)
We then say: Debit to INCREASE an Expense and Credit to DECREASE an Expense.
To summarize, Income and Expenses are factors that affect the Owner’s Equity. Income increases Owner’s
Equity while Expenses decrease Owner’s Equity. Owner’s Equity is increased by a credit to Income and is decreased
by a debit to Expense.
RULES OF DEBIT AND CREDIT

The accounting equation reflects the normal balance of the three accounting values as well as the temporary
accounts of an Owner’s Equity account. The “side positioning” as adopted to effect the increases and decreases of
their respective amounts can be gleaned further with the developed rules of debit and credit which are stated as
follows:
We DEBIT to: We CREDIT to:

RULE 1 Increase an Asset Decrease an Asset
RULE 2 Decrease a Liability Increase a Liability
RULE 3 Decrease an Owner’s Equity Increase an Owner’s Equity
TEMPORARY ACCOUNTS
RULE 4 Increase in Drawing Decrease in Drawing
RULE 5 Decrease an Income Increase an Income
RULE 6 Increase an Expense Decrease an Expense
OR
DR CR
Assets + -
Liabilities - +
Capital - +
Drawing + -
Revenue - +
Expense + -
APPLICATION OF THE RULES #1

Transaction: Debit Credit
1. Cash investment by the Owner Cash Capital
2. Purchase of office supplies on account Office supplies Accounts payable
3. Payment of an account payable Accounts payable Cash
4. Rendered service to customers cash received Cash Service revenue
5. Payment of expenses Expenses Cash
6. Rendered service to customers on account Accounts receivable Service revenue
7. Collection of accounts receivable Cash Accounts receivable
8. Cash withdrawal by the owner Drawing Cash
APPLICATION OF THE RULES #2

The following selected transactions are given to illustrate the application of the rules of debit and credit
through side positioning. ASSET is represented by the account “Cash”, LIABILITY by the account “Accounts
Payable”, OWNER’S EQUITY by the account “Rosario Salva, Capital”, DRAWING by the account “Rosario Salva,
Personal”, INCOME by the account “Service Income”, and EXPENSE by the account “Stationery and Office Supplies
Expense”.
Transaction No. 1 – Mrs. R. Salva made an initial investment of PHP10,000 cash.
Analysis: Debit, Cash of PHP10,000 and Credit, R. Salva, Capital of PHP10,000.

Rule: Debit, increase in Asset and credit, increase in Owner’s Equity.
CASH
DEBIT CREDIT
PHP10,000
R. SALVA, CAPITAL
DEBIT CREDIT
PHP10,000
Note the Effect:

CASH ACCOUNT – Cash was debited and the amount of PHP10,000 was entered on the
increase side which is in its normal balance (positive) being an Asset account.
OWNER’S EQUITY ACCOUNT – R. Salva, Capital was credited and the amount of
PHP10,000 was entered on the increase side which is in its normal balance (positive) being
an Owner’s Equity account.
Transaction No. 2 – Mrs. R. Salva made an additional investment of PHP15,000 cash.
Analysis: Debit, Cash of PHP15,000 and Credit, R. Salva, Capital of PHP15,000.

Rule: Debit, increase in Asset and credit, decrease in Owner’s Equity.
CASH
DEBIT CREDIT
PHP10,000
PHP15,000
PHP25,000
R. SALVA, CAPITAL
DEBIT CREDIT
PHP10,000
PHP15,000
PHP25,000
Note the Effect:

CASH ACCOUNT – Cash was debited and the amount of PHP15,000 was entered on the
increase side which had increased the amount of cash to PHP25,000. The amount
PHP15,000 was positioned at the positive side of the account to effect the increase.
OWNER’S EQUITY ACCOUNT – R. Salva, Capital was further credited and the amount of
PHP15,000 was entered on the increase side which had increased the amount of capital to
PHP25,000. The amount PHP15,000 was positioned at the positive side of the account to
effect the increase.
Transaction No. 3 – Mrs. R. Silva made a cash withdrawal of PHP2,000.
Analysis: Debit, R. Silva Drawing of PHP2,000 and credit, Cash of PHP2,000.

Rule: Debit, decrease in Owner’s Equity (increase in Drawing) and credit, decrease in Asset.
CASH
DEBIT CREDIT
PHP10,000
PHP15,000 PHP2,000
PHP25,000 PHP2,000
PHP23,000
R. SALVA, CAPITAL
DEBIT CREDIT
PHP10,000
PHP15,000
PHP25,000
R. SALVA, DRAWING
DEBIT CREDIT
PHP2,000
Note the Effect:

CASH ACCOUNT – Cash was credited and the amount of PHP2,000 was entered on the
decrease side which has decreased the amount of cash balance to PHP23,000. The amount
PHP2,000 was positioned at the negative side to effect the decrease.
OWNER’S EQUITY ACCOUNT – The PHP2,000 reduction of capital was shown in another
account “R. Salva, Drawing” and not on the decrease side of the “R. Salva, Capital” account.
Take note that the “Drawing” account has an opposite side with the “Capital” account.
The “Capital” account is positioned as credit, while the “Drawing” account is positioned as
a debit to effect the decrease. The Capital of R. Salva had been decreased to PHP23,000.
Transaction No. 4 – Mrs. R. Salva made another cash withdrawal of PHP3,000.
Analysis: Debit, R. Salva, Drawing of PHP3,000 and credit, Cash of PHP3,000.

Rule: Debit, decrease in Owner’s Equity (increase in Drawing) and credit, decrease in Asset.
CASH
DEBIT CREDIT
PHP10,000
PHP15,000 PHP2,000
PHP3,000
PHP25,000
PHP5,000
PHP20,000
R. SALVA, CAPITAL
DEBIT CREDIT
PHP10,000
PHP15,000
PHP25,000
R. SALVA, DRAWING
DEBIT CREDIT
PHP2,000
PHP3,000
PHP5,000
Note the Effect:

CASH ACCOUNT – Cash was further credited and the amount of PHP3,000 was entered on
the decrease side. The PHP3,000 increased the total amount of the credit side to PHP5,000
while the total amount of the debit side was PHP25,000. In effect, the balance of cash
account had been decreased to PHP20,000.
OWNER’S EQUITY ACCOUNT – The PHP3,000 was entered on the increase side of the
“Drawing” account which means that the increase in “Drawing” account will further
decrease the balance of the “Owner’s Equity” account as they are in the opposite position.
The “Drawing” account had increased its balance to PHP5,000 which resulted to a further
decrease in “Owner’s Equity” account from PHP23,000 to PHP20,000.
Transaction No. 5 – Bought Stationery and Office Supplies on account from University Supply, PHP1,000.
Analysis: Debit, Stationery and Office Supplies Expense of PHP1,000 and credit, Accounts Payable of
PHP1,000.
Rule: Debit, increase in Expenses (decrease in Owner’s Equity) and credit, increase in Liabilities.
STATIONERY AND OFFICE SUPPLIES
DEBIT CREDIT
PHP1,000
ACCOUNTS PAYABLE
DEBIT CREDIT
PHP1,000
Note the Effect:

STATIONERY AND OFFICE SUPPLIES EXPENSE – was debited and the amount of
PHP1,000 was entered on the increase side which is in its normal balance (Positive) being
an Expense account.
ACCOUNTS PAYABLE – was credited and the amount of PHP1,000 was entered on the
increase side which is in its normal balance (Positive) being an Liability account.
Transaction No. 6 – Bought Stationery and Office Supplies on account from Visayan Educational Supply,
PHP2,500.
Analysis: Debit, Stationery and Office Supplies Expense of PHP2,500 and credit, Accounts Payable of
PHP2,500.
Rule: Debit, increase in Expenses (decrease in Owner’s Equity) and credit, increase in Liability.
STATIONERY AND OFFICE SUPPLIES
DEBIT CREDIT
PHP1,000
PHP2,500
PHP3,500
ACCOUNTS PAYABLE
DEBIT CREDIT
PHP1,000
PHP2,500
PHP3,500
Note the Effect:

STATIONERY AND OFFICE SUPPLIES EXPENSE – the amount of PHP2,500 was entered on
the increase side (Positive) of the account which resulted to increase the amount of
Stationery and Office Supplies Expense to PHP3,500.
ACCOUNTS PAYABLE – the amount of PHP2,500 was entered on the increase side
(Positive) of the account which resulted to increase the amount of Accounts Payable to
PHP3,500.
Transaction No. 7 – Partial payment of account with University Supply, PHP600.
Analysis: Debit, Accounts Payable of PHP600 and credit, Cash of PHP600.

Rule: Debit, decrease in Liability and credit, decrease in Assets.
CASH
DEBIT CREDIT
PHP10,000 PHP2,000
PHP15,000 PHP3,000
PHP25,000 PHP600
PHP19,400 PHP5,600
ACCOUNTS PAYABLE
DEBIT CREDIT
PHP1,000
PHP600 PHP2,500
PHP600 PHP3,500
PHP2,900
Note the Effect:

CASH ACCOUNT – the amount of PHP600 was entered on the decrease side of the account
which means that cash will be decrease by PHP600. The amount of PHP600 has increased
the credit side amount of cash toPHP5,600. This resulted to a further decrease of the cash
account balance from PHP20,000 to PHP19,600.
ACCOUNTS PAYABLE – the amount of PHP600 was debited and was entered on the
decrease side of the account. Since it was positioned on the opposite side of the account’s
normal balance (Positive), it decreased its balance from PHP3,500 to PHP2,900.
Transaction No. 8 – Partial payment of account with Visayan Educational Supply, PHP1,500.
Analysis: Debit, Accounts Payable of PHP1,500 and credit, Cash of PHP1,500.

Rule: Debit, decrease in Liability and credit, decrease in Asset.
CASH
DEBIT CREDIT
PHP10,000 PHP2,000
PHP15,000 PHP3,000
PHP600
PHP25,000 PHP1,500
PHP17,900 PHP7,100
ACCOUNTS PAYABLE
DEBIT CREDIT
PHP1,000
PHP600 PHP2,500
PHP1,500
PHP3,500
PHP2,100
PHP1,400
Note the Effect:
CASH ACCOUNT – the amount of PHP1,500 was credited and entered on the decrease side
of the account which means that Cash will be decrease further by PHP1,500. This amount
further increased the credit side amount to PHP7,100 which in effect reduced the amount
of cash account from PHP19,400 to PHP17,900.
ACCOUNTS PAYABLE – the amount of PHP1,500 was debited and entered on the decrease
side of the account which means that Accounts Payable account will be decreased further
by the said amount. While this amount increased the debit side of the account to PHP2,100,
in effect reduced the amount balance of the account from PHP2,900 to PHP1,400.
Transaction No. 9 – Received cash for services rendered to Mario Daray, PHP4,000.
Analysis: Debit, Cash of PHP4,000 and credit, Service Income of PHP4,000.

Rule: Debit, increase in Asset and credit, increase in Income (increase in Owner’s Equity).
CASH
DEBIT CREDIT
PHP10,000 PHP2,000
PHP15,000 PHP3,000
PHP4,000 PHP600
PHP29,000 PHP1,500
PHP21,900 PHP7,100
SERVICE INCOME
DEBIT CREDIT
PHP4,000
Note the Effect:

CASH ACCOUNT – the amount of PHP4,000 was debited and entered in the increase side of
the account. This had increased the amount balance of cash account from PHP17,900 to
PHP21,900.
SERVICE INCOME – the amount of PHP4,000 was credited and entered in the increase side
of the account which is in its normal balance (Positive) being an Income account.
Transaction No. 10 – Received cash for services rendered to Marian Aparo, PHP6,000.
Analysis: Debit, Cash of PHP6,000 and credit, Service Income of PHP6,000.

Rule: Debit, increase in Asset and credit, increase in Income (increase in Owner’s Equity).
CASH
DEBIT CREDIT
PHP10,000
PHP15,000 PHP2,000
PHP4,000 PHP3,000
PHP6,000 PHP600
PHP1,500
PHP35,000
PHP7,100
PHP27,900
SERVICE INCOME
DEBIT CREDIT
PHP4,000
PHP6,000
PHP10,000
Note the Effect:

CASH ACCOUNT – the amount of PHP6,000 was debited and entered on the increase side of
the account which had increased the amount of cash balance from PHP21,900 to
PHP27,900.
SERVICE INCOME – the amount of PHP6,000 was credited and entered on the increase side
of the account which had increased the amount of Service Income from PHP4,000 to
PHP10,000. The said amount was positioned on the positive side of the account to effect the
increase.
Shown below is the summary of DEBIT and CREDIT entries of each account:
CREDIT BALANCES IN AMOUNT

DEBIT ENTRIES
ENTRIES DEBIT CREDIT
Cash (Asset) PHP35,000 PHP7,100 PHP27,900
Accounts Payable (Liability) PHP2,100 PHP3,500 PHP1,400
R. Salva, Capital (Owner’s Equity) PHP25,000 PHP25,000
TEMPORARY ACCOUNTS
R. Salva, Drawing (Drawing) PHP5,000 PHP5,000

Service Income (Income) PHP10,000 PHP10,000
Stationery and Office Supplies (Expense) PHP3,500 PHP3,500
TOTAL PHP45,600 PHP45,600 PHP36,400 PHP36,400
Take Note:
Both the totals of Debit and Credit entries of all accounts showed an equal balance of PHP45,600.
This proves the equality of Debit and Credit as expressed in the equation,
𝐃𝐄𝐁𝐈𝐓 = 𝐂𝐑𝐄𝐃𝐈𝐓.
Likewise, the difference between the debit and credit entries of each account when totalled will also
result to an equal balance of PHP36,400. This resulted to this effect because whichever side of the account
showed a bigger balance, the difference also reflects or carries the sign of the side which has a bigger
balance.
Summary of Changes in Temporary Accounts of Owner’s Equity
Service Income PHP10,000

Less: Expenses 3,500
Net Operating Income PHP6,500
R. Salva, Capital, Beginning PHP10,000

Add: Additional Investment of Salva PHP15,000
Net Income 6,500 21,500
TOTAL PHP31,500
Less: R. Salva, Drawing 5,000
R. Salva, Capital, End PHP26,500
Take note, that the above summary of changes in temporary accounts of owner’s equity is in itself
an Income Statement because it shows Income less Expenses equals Net Operating Income.
The Owner’s Equity, Beginning plus Additional Investment and Net Income less Drawing equals
Owner’s Equity, End which is in itself the Statement of Changes in Equity.
The Summary of Changes in Accounting Values when placed in an equation will show the following
results:
Assets = Liabilities + Owner’s Equity
PHP27,900 = PHP1,400 + PHP26,500
FINANCIAL STATEMENTS
Financial statements are the means by which the information accumulated and processed in financial
accounting are periodically communicated to the users. They are designed to serve the needs of variety of users,
particularly owner and creditors.
The objective of financial statements is to provide information about the financial position, performance and
cash flows of an enterprise that is vital in making a sound economic decisions.
There are five (5) basic financial statements as per ASC No. 1 (Revise 2000), namely: Balance Sheet, Income
Statement, Statement of Changes in Equity, Statement of Cash Flows, and Accounting Policies and Notes to Financial
Statements.
BALANCE SHEET
It is a financial statement which shows the financial position of an enterprise as of a particular fate. It
consists of three (3) sections which are the Assets, Liabilities, and Owner’s Equity section. A balance sheet is always
dated as follows:
“As of specific date ”
Shown below is the Balance Sheet of Pagadian Laundry Services as of March 31, 20xx.
ABC Laundry Services

Balance Sheet
As of 31 March 20xx
ASSETS
Current Assets:
Cash in Bank P 743,000
Accounts Receivable P 35,000
Less: Allow. For Bad Debts 350 34,650
Laundry Supplies 70,000
Total Current Assets P 847,650
Non-Current Assets:
Property and Equipment:
Laundry Equipment P 150,000
Less: Accumulated Depreciation 2,500
Total Non-Current Assets 147,000
The Balance Sheet answers
the following questions:
Total Assets P 995,150
How much the business owns?

LIABILITY & OWNER’S EQUITY (Referring to Assets)
LIABILITIES
Current Liabilities How much the business owes?
(Referring to Liabilities)
Notes Payable P 100,000
Accounts Payable 30,000
Accrued Advertising 3,000
Total Current Liabilities P 133,000
OWNER’S EQUITY How much is left for the business?

(Referring to Owner’s Equity)
S. Santos, Capital 862,150
Total Liabilities and Owner’s Equity P 995,150
The balance sheet measures and evaluates in terms of the enterprise’s liquidity, solvency, financial
structure, and capacity for adaptation. Liquidity is the ability of the enterprise to meet currently maturing
obligations. Solvency is the availability of cash over the longer term to meet maturing obligations. Financial
Structure is the source of financing for the assets of the enterprise. Capacity for Adaptation is the financial
flexibility of the enterprise to use the available cash for unexpected requirements and investment opportunities.
INCOME STATEMENT
It is a financial statement which shows the performance of the enterprise for a given period of time. The
performance if the enterprise is primarily measured in terms of the level of income earned by the enterprise through
effective and efficient utilization of its resources.
The information presented in an income statement is usually considered the most important information
provided by financial accounting because profitability is a paramount concern to those interested in the economic
activities of the enterprise.
The period covered by the income statement may be:
 “For the month ended”
 “For the year ended”

 “For the quarter ended”
 Or any accounting period that may be chosen
Shown below is the Income Statement of Pagadian Laundry Services for the month ended March 31, 20xx.

Income Statement
For the month ended 31 March 20xx
Revenue:
Laundry Income P 80,000
Operating Expenses:
Bad Debts P 350
Depreciation Expense 2,500 The Income Statement answers

the following questions:
Salaries Expense 10,000
Rent Expense 5,000 Does the business make profit?
Utilities Expense 10,000 Does the business incur a loss?
Laundry Supplies Expense 20,000 Does the business make no profit

and incur no loss?
Taxes & Licenses 4,000
Advertising Expense 3,000 56,850
Operating Income P 23,150
Less: Finance Charges
Interest Expense 1,000
Net Income P 22,150
The business makes profit is total income earned exceeds total expenses incurred. If total expenses incurred
exceed total income earned, the business incurs a loss. The business is said to be at break-even if total income
earned is equal to the total expenses incurred.
STATEMENT OF CHANGES IN EQUITY

It is a financial statement that summarizes the changes in equity for a given period of time. The beginning
equity of the owner is increased by the additional investment and net income. Correspondingly, it is decreased by
withdrawal and net loss.
Shown below is the Statement of Changes in Owner’s Equity of Pagadian Laundry Services for the month
ended March 31, 20xx.

Statement of Changes in Equity
For the month ended 31 March 20xx The Statement of Changes in
Owner’s Equity answers the
S. Santos, Owner’s Equity – March 1, 20xx P 850,000 following question:
Add: Additional Investment P–0–
Net Income 22,150 22,150 What causes the increase in
Owner’s Equity of Mr. Santos
from P 850,000 to P 862,150?
Total 872,150
Less: Withdrawal 10,000
S. Santos, Owner’s Equity – March 31, 20xx P 862,150
In an event wherein an owner’s withdrawal exceeds the net operating income of the business, there is a Net
Decrease in Owner’s Equity, hence, beginning Owner’s Equity will also be decreased.
STATEMENT OF CASH FLOWS

It is a financial statement that provides information about cash inflows (Receipts) and cash outflows
(Payments) of an entity for a given period of time which are being classified into the following activities:
a) Operating Activities – the inflows and outflows of cash from the normal operating activities of the
business.
b) Investing Activities – the inflows and outflows of cash from the sale or purchase of assets other than
inventory.
c) Financing Activities – the inflows and outflows of cash from the owners and creditors of the
enterprise.
This shows the net increase or decrease in cash during the period and the cash balance at the end of the
period.
Shown below is the Statement of Cash Flows of Pagadian Laundry Services for the month ended March 31,
20xx.

Statement of Cash Flows
For the month ended 31 March 20xx
Cash Flows from Operating Activities:

The Statement of Cash
Cash receives from customers P 45,000
Flows answers the
Payment of taxes and licenses (4,000) following questions:
Payment of laundry supplies (60,000)
Where did the cash come
Payment of salaries (10,000)
from during the period?
Payment of rental expense (5,000)
(Referring to the sources or
Payment of utilities (12,000)
cash inflows)
Payment of interest (1,000)
Net cash provided by (used in) operating activities (P 47,000) Where did the cash go?
Cash Flows from Investing Activities: (Referring to the uses or
Purchases of laundry equipment (150,000) cash outflows)
Net cash provided by (used in) investing activities (150,000)
Cash Flows from Financing Activities:

Cash received as investment by owner 850,000
Cash received from borrowings 100,000
Payment for withdrawal by owner (10,000)
Net cash provided by (used in) financing activities 940,000
Net Increase (Decrease) in Cash P 743,000

Cash Balance at the beginning of the period -
Cash Balance at the end of period P 743,000
ACCOUNTING POLICIES AND NOTES TO FINANCIAL STATEMENTS

This is an integral part of the financial statements. This presents significant accounting policies that affected
the financial statements and included supporting schedules of computations and disclosures of some events and
other information essential to understanding the company’s accounts.
QUALITIES THAT FINANCIAL STATEMENTS SHOULD POSSESS

The new framework of accounting mentions that the following are the qualities that financial reports should
possess to be more useful, to wit:
1) Understandability
 This means that financial statements should be prepared and presented in a way that it can be
understood by the users.
 Users are expected to study the financial information with reasonable diligence and assumed to
have reasonable knowledge of business, economics, and accounting.
2) Reliability
 Financial information should carry the degree of confidence when used by interested parties.
 To be reliable, it must be “free from material error” that will lead to material misstatement, it
must be fairly presented and must be free from bias.
 The Accounting Standards Council’s (ASC’s) new accounting framework provides that in order
to become reliable, the financial reports should possess the following characteristics:
a. Faithful representation – accountants should properly report the actual events and
their respective amounts in the financial statements as objectively as possible.
b. Neutrality – financial reports should be fairly presented and must be free from bias.
c. Conservatism – under this doctrine, when alternatives exist, the alternative which
has the least effect on owner’s equity should be chosen. As between two honestly
doubtful alternatives,
i. Understatement of assets and income
ii. Overstatement of assets and income, the former is preferred over the
latter. This is conservatism. It is expressed in this manner, “anticipate no
profit and provide for all losses.” In this new accounting framework
issued by the ASC, this conservatism concept is called the “prudence
convention”.
d. Completeness – financial statements are said to be complete if it contains full
disclosure of significant information necessary in order that the statement would not
be misleading.
e. Substance Over Form – financial accounting emphasizes the economic substance of
events even though the legal form may differ from the economic substance and
suggest different treatment.
3) Relevance
 This means that financial statements are prepared intended to help users make informed
economic decisions.
 The following major ingredients describe the relevance of a financial statement:
a. Materiality – there is no strict rule in determining whether an item is material or
not. Very often, this is dependent on judgment and common sense. In determining
materiality, judgment has to be focused on:
i. Size of the item in relation to the total of the group to which the item
belongs.
ii. Size of the company in terms of total sales or capital.
iii. Nature of the item – an item may be inherently material because by its
very nature it affects economic decision.
b. Predictive Value – the financial information enables the users to forecast and
make predictions about the outcome of the future events.
c. Feedback Value – the financial information enables the users to confirm past
predictions or correct earlier predictions.
d. Timeliness – financial information must be available at the time of need or else it
will defeat the purpose.
4) Comparability
 This means that financial statements prepared are worth comparing for with other companies
of the same line of business by pointing out similarities and differences.
5) Consistency
 Once a method or practice is selected from alternatives, it should be followed from period to
period.
 The consistency procedure or method does not only maintain the comparability of periodic
statements but also implants reliability in the reports.

FABM 1 Lesson 7 The Accounting Equation

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

FABM 1 Lesson 7 The Accounting Equation

Uploaded by

Copyright:

Available Formats

FUNDAMENTALS OF ACCOUNTANCY, BUSINESS, AND MANAGEMENT

Lesson 7: The Accounting Equation

𝐎𝐰𝐧𝐞𝐫′ 𝐬 (𝐨𝐫 𝐒𝐭𝐨𝐜𝐤𝐡𝐨𝐥𝐝𝐞𝐫′ 𝐬) 𝐄𝐪𝐮𝐢𝐭𝐲 = 𝐀𝐬𝐬𝐞𝐭𝐬 − 𝐋𝐢𝐚𝐛𝐢𝐥𝐢𝐭𝐢𝐞𝐬

BALANCE SHEET AND INCOME STATEMENT

Assets Invested By The Owner

ASSETS = LIABILITIES + OWNER’S EQUITY

Borrowings From The Bank

ASSETS = LIABILITIES + OWNER’S EQUITY

Asset Purchased For Cash

ASSETS = LIABILITIES + OWNER’S EQUITY

Assets Purchased On Account

ASSETS = LIABILITIES + OWNER’S EQUITY

Cash Withdrawal By The Owner

ASSETS = LIABILITIES + OWNER’S EQUITY

July 20 – The account due to Fortune was paid in cash.

ASSETS = LIABILITIES + OWNER’S EQUITY

Date ASSETS LIABILITIES OWNER’S EQUITY

Loans Accounts Reyes, Reyes,

Balances 850,000 55,000

Balances 795,000 200,000 45,000 55,000 100,000 0 (5,000) 1,000,000

Determining Profit through Operation

 EQUIPMENT (Property, Plant and Equipment / PP&E)

iii. Owner’s / Shareholder’s Equity:

Bank +$10,000 Owner’s Equity +$10,000

Account Amount Account Amount

Bank $10,000 Loan $10,000

Account Amount Account Amount

Bank $5,000 Owner’s Equity $5,000

Account Amount Account Amount

Bank -$10,000 Loan -$10,000

Account Amount Account Amount

Account Amount Account Amount

Bank $20,000 Loan $9,000

Oven $2,000 Owner’s Equity $15,000

Draw (Withdrawals) Liabilities

To illustrate: Shown below is a T-Account for the item Cash:

Debit Total P45,000 P15,000 Credit Total

DEBIT SIDE CREDIT SIDE

DEBIT SIDE CREDIT SIDE

DEBIT SIDE CREDIT SIDE

DEBIT SIDE CREDIT SIDE

DEBIT SIDE CREDIT SIDE

DEBIT SIDE CREDIT SIDE

RULES OF DEBIT AND CREDIT

We DEBIT to: We CREDIT to:

APPLICATION OF THE RULES #1

APPLICATION OF THE RULES #2

Transaction No. 1 – Mrs. R. Salva made an initial investment of PHP10,000 cash.

Analysis: Debit, Cash of PHP10,000 and Credit, R. Salva, Capital of PHP10,000.

Note the Effect:

Transaction No. 2 – Mrs. R. Salva made an additional investment of PHP15,000 cash.

Analysis: Debit, Cash of PHP15,000 and Credit, R. Salva, Capital of PHP15,000.

Note the Effect:

Transaction No. 3 – Mrs. R. Silva made a cash withdrawal of PHP2,000.

Analysis: Debit, R. Silva Drawing of PHP2,000 and credit, Cash of PHP2,000.

Note the Effect:

Transaction No. 4 – Mrs. R. Salva made another cash withdrawal of PHP3,000.

Analysis: Debit, R. Salva, Drawing of PHP3,000 and credit, Cash of PHP3,000.

Note the Effect:

STATIONERY AND OFFICE SUPPLIES

Note the Effect:

Note the Effect:

Transaction No. 7 – Partial payment of account with University Supply, PHP600.