7 The Accounting Equation (4 Pages)

FUNDAMENTALS OF ACCOUNTANCY, BUSINESS AND MANAGEMENT 1
The Accounting Equation
OBJECTIVES
At the end of the session, the learners should be able to
1. define the elements of financial statements;
2. describe the account (the simple T-Account) and its uses;
3. illustrate the accounting equation; and
4. perform operations involving simple cases with the use of accounting equation.
The starting point in the accounting process is an analysis of the transactions of a business. A business transaction is any
financial event that changes the resources of a firm. For example, purchases, sales, payments and receipt of cash are a\i
business transactions. The accountant must look at the effects of each business transaction to decide what information
to record and where to record it. Thus, the study of accounting begins with an investigation into how the accountant
analyzes business transactions
ACCOUNTING EVENTS AND TRANSACTIONS

An accounting event is an economic occurrence that causes changes in an enterprise's assets, liabilities, and/or equity.
Events may be internal actions, such as the use of equipment for the production of goods or services. It can also be an
external event, such as the purchase of raw materials from a supplier.
A transaction is a particular kind of event that involves the transfer of something of value between two entities.
Examples of transactions include acquiring assets from owner(s), borrowing funds from creditors, and purchasing or
selling goods and services.
ELEMENTS OF FINANCIAL STATEMENTS (objective 1)
Financial Position
At regular intervals the business will review the status of the firm's assets, liabilities, and owner’s equity in a formal
report called a balance sheet, which is prepared to show the firm's financial position on a given date.
Asset is a resource controlled by the enterprise as a result of past events and from which future economic benefits are
expected to flow to the enterprise (per IFRS Framework). In simple terms, assets are valuable resources owned by the
entity. Assets include cash, cash equivalents, notes receivable, accounts receivable, inventories, prepaid expenses,
property, plant and equipment, investments, intangible assets and other assets.
Liability is a present obligation of the enterprise arising from past events, the settlement of which is expected to result
in an outflow from the enterprise of resources embodying economic benefits (per IFRS Framework). A plain definition
would be-- liabilities are obligations of the entity to outside parties who have furnished resources. Liabilities include
notes payable, accounts payable, accrued liabilities, unearned revenues, mortgage payable, bonds payable and other
debts of the enterprise.
Equity is the residual interest in the assets of the enterprise after deducting all its liabilities (per IFRS Framework). Equity
may pertain to any of the following depending on the form of business organization:
 In a sole proprietorship, there is only one owner's equity account because there is only one owner.
 In a partnership, an owner’s equity account exists for each partner.
 In a corporation, owners' equity, or shareholders' or stockholders' equity, consists of share capital or capital
stock, retained earnings and reserves representing appropriations of retained earnings among others.
Performance
If there is an excess of revenue over expenses, the excess represents a profit. Making a profit is the reason that people
risk their money by investing it in a business. A firm's accounting records show not only increases and decreases in
assets, liabilities, and owner’s equity but the detailed results of all transactions involving revenue and expenses.
Income is increases in economic benefits during the accounting 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 contributions from· equity
participants (per IFRS Framework).
The definition of income encompasses both revenue and gains.

Revenue arises in the course of the ordinary activities of an enterprise and is referred to by a variety of different names
including sales, fees, interest, dividends, royalties, and rent.
Gains represent other items that meet the definition of income and may, or may not, arise in the course of the
ordinary activities of an enterprise. Gains represent increases
in economic benefits and as such are no different in nature from revenue. Hence, they are not regarded as constituting a
separate element.
Expenses are decreases in economic benefits during the accounting period in the form of outflows or depletions of
assets or incurrence of liabilities that result in decreases in equity, other than those relating to distributions· to equity
participants (per IFRS Framework).
The definition of expenses encompasses losses as well as those expenses that arise in the course of the ordinary
activities of the enterprise. There are various classes of expenses but they are generally classified as cost of services
rendered or cost of goods sold, distribution costs or selling expenses, administrative expenses or other operating
expenses.
Losses represent other items that meet the definition of expense and may or may not, arise in the course of the·
ordinary activities of an enterprise. Losses represent decreases in economic benefits and as such are no different in
nature from other expenses. Hence, they are not regarded as a separate element.
THE ACCOUNT (objective 2)

The basic summary device of accounting is the account: A separate account is maintained for each element that appears
in the balance sheet (assets, liabilities and equity and in the income statement (income and expenses). Thus, an account
may be defined as a detailed record of the increases, decreases and balance of each element that appears in an entity's
financial statements. The simplest form of the account is known as the "T" account because of its similarity to the letter
"T". The account has three parts as shown next page:
THE ACCOUNTING EQUATION (objective 3)

Financial statements tell us how a business is performing. They are the final products of the accounting process. But how
do we arrive at the items and amounts that make up the financial statements? The most basic tool of accounting is the
accounting equation. This equation presents the resources controlled by the enterprise, the present obligations of the
enterprise and the residual interest in the assets. It states that assets must always equal liabilities and owner's equity.
The basic accounting model is:
Note that the assets are on the left side of the equation opposite the liabilities and owner's equity. This explains why
increases and decreases in assets are recorded in the opposite manner ("mirror image") as liabilities and owner's equity
are recorded. The equation also explains why liabilities and owner's equity follow the same rules of debit and credit.
The logic of debiting and crediting is related to the accounting equation. Transactions may require additions to both
sides (left and right sides), subtractions from both sides (left and right sides), or an addition and subtraction on the same
side (left or right side), but in all cases the equality must be maintained as shown below:
EXERCISES
Part 1. Elements of Financial Statements
Assets Liabilities Owner’s Equity
A 760,000 360,000 ?
B 860,000 ? 592,000
C ? 108,000 760,000
D 626,600 376,240 ?
E ? 800,000 (100,000）
Required: Fill in the amount of the missing element of financial position.
Part 2. Income Expenses Profit

Income Expenses Profit
(Loss)
A 840,000 ? 360,000
B 2,400,000 ? 540,000
C 1,300,000 860,000 ?
D ? 2,000,000 720,000
E ? 1,800,000 (400,000）
Required: Supply the missing element of performance.
Part 3. Transaction Effects on the Basic Accounting Model

The following are some transactions of Rikki Travel & Tours Services:
A L OE
a. Received cash as additional investment. _________ _________ _________
b. Purchased supplies on account. _________ _________ _________
c. Charged customers for services made on
account. _________ _________ _________
d. Rendered services to cash customers. _________ _________ _________
e. Paid cash for rent on building. _________ _________ _________
f. Collected on account receivable in full. _________ _________ _________
g. Paid cash for supplies. _________ _________ _________
h. Returned supplies purchased on account. _________ _________ _________
i. Paid cash to settle accounts. _________ _________ _________
j. Paid cash to owner for personal use. _________ _________ _________
For each transaction, indicate whether the assets (A), liabilities (L) or owner's equity (OE) increased (↑), decreased (↓)
or did not change (0) by placing the appropriate sign in the appropriate column.
Part 4. Owner’s Equity Transaction
________ a. Received cash for rendering services.
________ b. Withdrew cash for personal expenses.
________ c. Received cash from a customer who have been. Rendered service on account.
________ d. Transferred personal assets to the business.
________ e. Paid a service station for gasoline for a business service vehicle.
________ f. Performed a service and received a promise of payment.
________ g. Paid cash to acquire equipment.
________ h. Paid cash to an employee for services rendered.
Required:
Identify the foregoing transactions by identifying each as either one of the following: owner's investment (OI), owner's
withdrawal (OW), income (I), expense (E) or not an owner's equity transaction (NO).
Part 5. Effects of Transactions

The following selected transactions were completed by PolMed Freight Services during July 2016:
________1. Cash received from delivery services, P92,700.
________2. Paid creditors on account, P20,000.
________3. Received cash from owner as additional investment, P600,000.
________4. Paid advertising expense, P5,000.
________5. Billed customers for delivery services on account, P55,200.
________6. Purchased supplies for cash, P6,000.
________7. Paid rent for July, P20,000.
________8. Received cash from customers on account, P25,440.
________9. Determined that the cost of supplies on hand was P1,440 so P4,560 of supplies were
used during the month.
________10. Owner withdrew cash for personal use, P20,000.
Indicate the effects of each transaction on the space provided:

a. Increase an asset, decrease another asset.
b. Increase an asset, increase a liability.
c. Increase an asset, increase owner's equity.
d. Decrease an asset, decrease a liability.
e. Decrease an asset, decrease owner's equity.

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FUNDAMENTALS OF ACCOUNTANCY, BUSINESS AND MANAGEMENT 1

The Accounting Equation

ACCOUNTING EVENTS AND TRANSACTIONS

ELEMENTS OF FINANCIAL STATEMENTS (objective 1)

The definition of income encompasses both revenue and gains.

THE ACCOUNT (objective 2)

THE ACCOUNTING EQUATION (objective 3)

The basic accounting model is:

Required: Fill in the amount of the missing element of financial position.

Part 2. Income Expenses Profit

Required: Supply the missing element of performance.

Part 3. Transaction Effects on the Basic Accounting Model

Part 5. Effects of Transactions

Indicate the effects of each transaction on the space provided:

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