CHAPTER 3 – THE ACCOUNTING EQUATION

Learning outcomes:
1. Student will be able to define each of the elements of financial statements and use those
definitions in determining the existence of an asset, liability, equity, income or expense.
2. Student will be able to illustrate the accounting equation.
3. Student will be able to use the accounting equation in solving accounting problems.

Methodology:
- Courseware/Limited face-to-face

Lecture/Discussion:
The Basic Accounting Equation
➢ All the processes in an accounting system must observe the equality of the accounting equation,
which is basically an algebraic equation. The basic accounting equation is shown below:
ASSETS = LIABILITIES + EQUITY

Elements of a Financial Statements

1. ASSETS – are the economic resources you control that have resulted from past events and can
provide you with economic benefits. Examples include: cash, accounts receivable, land,
equipment, etc.

2. LIABILITIES – are your present obligations that have resulted from past events and can require
you to give up economic resources when settling them. Examples include: accounts payable,
salaries payable, utilities payable, etc.

3. EQUITY – is simply assets minus liabilities. Other terms for equity are “capital”, “net assets” and
“net worth”.

The Expanded Accounting Equation

ASSETS = LIABILITIES + EQUITY + INCOME – EXPENSES

4. INCOME – is increases in economic benefits during the period in the form of increases in assets,
or decreases in liabilities, that result in increases in equity, excluding those relating to investments
by the business owner. Examples include: sales, gains, rent income, etc.

5. EXPENSES – are decreases in economic benefits during the period in the form of decreases in
assets, or increases in liabilities, that result in decreases in equity, excluding those relating to
distributions to the business owner.

The difference between income and expenses represents profit or loss. If income is greater than
expenses, the difference is profit or if the other way around, the difference is loss.

Application of the Accounting Equation

Case 1: If you have total liabilities of P1,200 and equity of P800, how much are your total assets?
ASSETS = LIABILITIES + EQUITY
? 1,200 800
Answer: Total assets = 1,200+800 = 2,000

Case 2: If you have total assets of P2,000 and equity of P800, how much are your total liabilities?
ASSETS = LIABILITIES + EQUITY
2,000 ? 800
Answer: Total liabilities = 2,000 - 800 = 1,200
Case 3: If you have total assets of P2,000 and total liabilities of P1,200, how much are your total
equity?
ASSETS = LIABILITIES + EQUITY
2,000 1,200 ?
Answer: Total equity = 2,000 – 1,200 = 800

Case 4.1: Profit or loss

If you have total income of P5,000 and total expenses of P2,000, how much is your profit or (loss)?
Solution:
Income P5,000
Less: Expenses 2,000
Profit P3,000

Case 4.2: Profit or loss

If you have total income of P6,000 and total expenses of P11,000, how much is your profit or (loss)?
Solution:
Income P6,000
Less: Expenses 11,000
Loss (P5,000)

Case 5: Income
If you have total expenses of P2,000 and a profit of P3,000, how much is your total income?
Solution:
Income ?
Less: Expenses 2,000
Profit 3,000 (squeeze upward)
Answer: Total income = 3,000 + 2,000 = 5,000

Case 6: Expenses
If you have total income of P5,000 and a profit of P3,000, how much is your total expenses?
Solution:
Income 5,000
Less: Expenses ? (squeeze)
Profit 3,000
Answer: Total expenses = 5,000 - 3,000 = 2,000

Case 7: Income
You have ending* total assets of P4,800, ending total liabilities of P1,000 and beginning* equity is
P800. If your total expenses for the period amount to P2,000, how much is your total income?

*(In accounting parlance, the term ‘beginning means ‘at the start’ of an accounting period while
‘ending means ‘at the end’ of an accounting period.)
Solution:
ASSETS = LIABILITIES + EQUITY + INCOME – EXPENSES
Beginning 800
Changes 3,000 ? 2,000
Ending 4,800 1,000 3,800
Answer: Total income = 4,800 – 1,000 – 800 + 2,000 = 5,000

Case 8: Income
You have ending total assets of P4,800, ending total liabilities of P1,000 and beginning* equity is
P800. If your total income for the period amount to P5,000, how much is your total expenses?
Solution:
ASSETS = LIABILITIES + EQUITY + INCOME – EXPENSES
Beginning 800
Changes 3,000 5,000 ?
Ending 4,800 1,000 3,800
Answer: Total expenses = 4,800 – 1,000 -800 - 5,000 = 2,000
Case 9.1: Ending equity
Your beginning equity is P5,000. If your total income for the period is P8,000, while your total
expenses are P6,000, how much is the ending balance of your equity?
Solution:
Equity, beginning P5,000
Add: Income 8,000
Less: Expenses 6,000
Equity, ending P7,000

OR

Equity, beginning P5,000

Add/(Less): Profit or loss 2,000
Equity, ending P7,000

Case 9.2: Ending equity

Your beginning equity is P12,000. If your total income for the period is P5,000, while your total
expenses are P8,000, how much is the ending balance of your equity?
Solution:
Equity, beginning P12,000
Add: Income 5,000
Less: Expenses 8,000
Equity, ending P9,000

Case 10.1: Profit for the period

If your beginning equity is P5,000, while your ending equity is P7,000, how much is your profit or loss
for the period?
Solution:
Equity, beginning P5,000
Add/(Less): Profit or loss ? (squeeze)
Equity, ending P7,000

Profit = 7,000 – 5,000 = 2,000

Case 10.2: Loss for the period

If your beginning equity is P6,000, while your ending equity is P2,000, how much is your profit or loss
for the period?
Solution:
Equity, beginning P6,000
Add/(Less): Profit or loss ? (squeeze)
Equity, ending P2,000

Loss = 2,000 – 6,000 = (4,000)

Case 11: Ending total assets

You had total assets, liabilities, and equity of P10,000, P7,000 and P3,000, respectively, at the
beginning of the period. During the period, your total liabilities decreased by P4,000, while your
profit was P5,000. How much are your ending total assets?
Solution:
ASSETS = LIABILITIES + EQUITY + INCOME – EXPENSES
Beginning 10,000 7,000 3,000 0 0
Changes (4,000) 5,000
Ending ? 3,000 8,000
Answer: Total asset, ending = 3,000 + 8,000 = 11,000

Case 12: Ending total assets

You had total assets, liabilities, and equity of P10,000, P7,000 and P3,000, respectively, at the
beginning of the period. During the period, your total liabilities decreased to P4,000, while your profit
was P5,000. How much are your ending total assets?
Solution:
ASSETS = LIABILITIES + EQUITY + INCOME – EXPENSES
Beginning 10,000 7,000 3,000 0 0
Changes 5,000
Ending ? 4,000 8,000
Answer: Total asset, ending = 4,000 + 8,000 = 12,000

--- END OF LECTURE NOTES ----

ACTIVITIES/ASSESSMENT TASK: 30 pts.

PROBLEM 1: TRUE OR FALSE
_____1. Income is defined as increase in assets or decreases in liabilities that result in an increase in
equity, other than those that relate to contributions by the business owner(s).
_____2. Both the definitions of income and expenses encompass changes in assets and liabilities but
excluding those changes that relate to business owner’s investments to, or withdrawals from, the
business.
_____3. You own a business. Your business lacks capital so you provided additional cash. This
transaction would result to income by your business.
_____4. The difference between income and expenses is profit or loss. There is profit if income
exceeds expenses.
_____5. Physical possession is a necessary condition in order to control over an asset to exist.
_____6. An economic resource can produce economic benefits in many ways, including the potential
of the resource to provide the entity, directly or indirectly, with cash.
_____7. The settlement of a liability requires the transfer of an economic resource.
_____8. An intention to obtain control over an economic resource at a future time does not result to
the recognition of an asset at present.
_____9. Your business has total assets of P10M, total liabilities of P6M and total equity of P4M. This
means that out of the total P10M resources, you have provided P6M.
_____10. Income decreases equity, while expenses increases equity.

PROBLEM 2: COMPUTATIONS
Instruction: Compute for the missing amounts.
ASSETS = LIABILITIES + EQUITY
1. P460,000 190,000 ?
2. P230,000 ? P70,000
3. ? P990,000 P130,000
4. P1,020,000 ? P410,000
5. P820,000 P580,000 ?

ASSETS = LIABILITIES + EQUITY + INCOME - EXPENSES

1. P590,000 P380,000 P130,000 210,000 ?
2. P490,000 P280,000 P40,000 ? P180,000
3. P860,000 P220,000 ? P360,000 P80,000
4. P360,000 ? P90,000 P180,000 P70,000
5. ? P410,000 P170,000 P480,000 P190,000

PROBLEM 2: COMPUTATIONS – ACCOUNTING EQUATION

Instruction: Determine the effects of the transactions or events described below on the basic
accounting equation.

Example: You invested P100 cash from your personal savings to your business.
Answer:
ASSETS = LIABILITIES + EQUITY
P100 0 P100
1.
2.
 3.
4.
5.

1. You found additional P20 underneath your pillow. You also invested this amount to your
business.
2. Your business obtained a loan of P500.
3. Your business earned income of P2,000 during the period. The income did not affect your
liabilities.
4. Your business incurred expenses of P800 during the period. The expenses did not affect your
liabilities.
5. Get the total of the assets, liabilities and equity, INCLUDING the effects of the given example
above. Check if the accounting equation is balanced.

--- NOTHING FOLLOWS ---