Chapter 3

THE ACCOUNTING EQUATION

LEARNINGOBJECTIVES

DEFINEOFTHEELEMENTSOFFINANCIALSTATEMENTSANDUSETH
OSEDEFINITIONSINDETERMININGTHEEXISTENCEOFANASSET,
LIABILITY,EQUITYINCOME,OREXPENSE
USETHEACCOUNTINGEQUATIONINSOLVINGACCOUNTINGPROB
LEMS.

THE BASIC ACC O UNTING E Q UATI O N

 In 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

ASSETS - are economic resources you control that have resulted from
past events and can provide you with economic benefits.
 Control
You don't necessarily need to own the economic resource for it is to be
considered to be your asset. What is important is that you
control the right over the economic benefits that the
resource may produce."Control" means that you have the exclusive rights
to enjoy those benefits and the ability to prevent others from enjoying
those benefits.
E XAMPLE 1 : R ES O UR CE OWNED BUT N O T C O NSIDE R ED AN
ASSET
You own a building. However, you do not have the right to use, sell, lease, or transfer(or other similar rights
over) the building-another party does.

ANALYSIS: The building is not your asset because you do not control the economic benefits from it, if you
are the legal owner.

E XAMPLE 2 : R ES O UR CE N O T OWNED BUT C O NSIDE R ED AN

ASSET
You acquired telecommunication on a 2-year installment plan. The agreement states that if you miss
an installment payment, the telecommunication can get the cellphone back.

ANALYSIS: Upon taking possession, the cellphone becomes your asset even if you do not own it yet
until you fully paid the installment price. This is because you control the right over the economic benefit
of the cellphone through exclusive use.

PAST E V ENTS
The control over an economic resource has resulted from past events or
transactions. Therefore for which control is yet to obtain in the future do not
qualify as assets in the present.
 For example, you have an intention of purchasing a cellphone next year. Right
now, the cellphone is not yet your asset. The cellphone becomes your asset after
you have purchased it and have possession over it.

Physical possession, however, is not always necessary for control to exist. For
example, the money that you have deposited to a bank remains your asset
despite the transfer of physical possession. This is because you still control the
right over the money but withdrawing it or spending it through electronic means.

EC O N OMIC B ENEFITS
To be an asset, the economic resource must have the potential to
provide you with economic benefits in at least one circumstance.

A. Sold, transferred, or exchange for other assets;

B. Used singly or in combination with other assets to produce goods or
provide services;
C. Used to enhance the value of other assets;
D. Used to promote efficiency and cost savings; or
E. Used to settle the liability.
L IAB I L ITIES
-are the present obligations that have resulted from past events and can
require you to give up economic resources when settling them.

Obligation
Obligation means duty or responsibility. An obligation is either:
 a.Legal Obligation-an obligation that results from a contract, legislation, or other
operation of law: or

b.Constructive obligation- an obligation that results from your past actions(e.g, past
practice or published policies) that have created a valid expectation on others that
you will accept and discharge certain responsibilities.
G I V ING UP O F EC O N OMIC R ES O UR CE

Settling the obligation necessarily would require you to pay cash to transfer other non
cash assets, or to render service.

P R ESENT O B L I GATI O N AS A R ESULTS O F PAST E V ENTS

 A present obligation exists as a result of past events if:
A. You have already obtained economic benefits or taken an action;
and B. As a consequence, you are required to transferan economic
resource.

E XAMPLES:
You have an intention to purchase a cellphone in the future.

ANALYSIS: You have no present obligation, and hence no liability, because you have not yet
purchased and received the cellphone, and therefore, you are not required to pay for the
purchased price.
You purchased a cellphone on credit. You took possession over the
cellphone but have not yet paid the purchased price.
ANALYSIS: You have a present obligation, and hence a liability,
because a. You have already purchased and received the cellphone,
and b. As a consequence, you are required to pay the purchased price.

Your obligation is a legal obligation because it arises from a

contract(i.e,,purchase contract).
You earned taxable income during the period but have not yet paid the tax
due to the government.

ANALYSIS:
You have a present obligation because:
a.you earned taxable income; and
b.as a consequence, you are required to pay the corresponding tax due.

Your obligation is a legal obligation because it arises from legislation(i.,e

tax law)
Although not stated in the sales contract, you have a publicly known policy of providing
free repair services for the goods your business sells. You have consistently honored
this implied policy in the past.

ANALYSIS: You have a present obligation to provide free repair services for the goods
you have already sold because:
 a. You have already taken an action by creating valid expectations on your customers
that you will provide free repair services; and
b. as a consequence, you will have to provide those free services.

Your obligation is a constructive obligation.

E Q UITY
-is simply assets minus liabilities. Other terms for equity are "capital ","net assets",
and "net worth"

Illustration 1
You decided to put up a barbeque stand and have estimated that you will be needing
P2,000 as start-up capital. You went to your closet and broke Mr. Piggy bank, which you
have been saving for quite some time now. Alas! you only have P800. You went to your
Mama and asked her to give you P1,200 but she told you that she has been feeding you
for far too long. Oh, man! But don't give up hope yet, Mr. Bombay is just around the
corner.
As of this point, your accounting equation is as follows:
ASSETS = LIABILITIES + EQUITY
800 = 0 + 800

Notes:
Your total assets are P800-the amount of economic resources that you control.
You don't have any liability yet because you are still negotiating with Mr. Bombay.
Your equity is also P800 (P800 assets-0 liabilities=800 equity)

After a lengthy negotiation, Mr. Bombay agreed to lend you P1,200.

At this point, your accounting equation is as follows:
ASSETS = LIABLITIES + EQUITY
2,000 = 1,200 + 800
Notes:
Your total assets are now P2,000 - the
total amount of economic resources that
you control(P800 from Mr. Piggy plus Liabilities represent the creditors' claim, while
P1,200 from Mr. Bombay) equity represents the owner's claim,againts the
total assets of the business

Of your total assets of P2,000

a.P1,200 represents your liability, the
amount you are obligated to pay Mr.
Bombay in the future. b. P800 represents
Notice that from Piggy to Bombay, the
your equity(i.,e, P2,000 assets P1,200
accounting equation remains
liabilities)
balanced. The equality of accounting ASSETS =LIABILITES +EQUITY
equation must be maintained in all 2,000 = 1,200 +800
accounting processes of recording,
classifying, and summarizing. If the
accounting equation doesn't balance,
there is something wrong. Variation #2
Original form of the equation: ASSETS
ASSETS= LIABILITIES EQUITY =LIABILITES
2,000 = 1,200 + 800 +EQUITY 2,000 = 800 + 1,200

Variation #1
THE E X PANDED ACC O UNTING E Q UATI O N
It shows all the financial elements.The expanded accounting equation is
as follows:
 ASSSETS= L IAB I L ITIES+E Q UITY+
INC OME-E X PENSES

INCOME-is increases in economic benefits during

the period in the form of increases in assets or than expenses, the differenceis loss.
decreases in liabilities, that result in increases in
equity, excluding those relating to investments by
the business owner.

Illustration 2:(Continuation of 'illustration 1

EXPENSES- are decreases in economic benefits
during the period in the form of decreases in assets,above)
or decreases in assets, or increases in liabilities,
that result in decreases in equity, excluding those During the period, you earned an income of
relating to distributions to the business owner. P10,000 and incurred expenses of P6,200. At
The difference between income and expenses the end of the period, your total assets
represents profit or loss.If income is greater than increased from P2,000 to P5,000, and your
expenses,the difference is profit If income is less
total liabilities decreased from P1,200 to
P400.
Y O UR E X PANDED ACC O UNTING E Q UATI O N IS
AS F O L L OWS;
ASSETS= L IAB I L ITIES+E Q UITY+ INC OME- E X
PENSES 5,000= 400 +800 +10,000-6,200

ASSET+EXPENSES =LIABILITIES+EQUITY+INCOME
This represents your equity from 'illustration 1' above. 5,000+6,200=400+800+10,000

Your profit for the period is P3,800(P10,000 income minus P6,200

We can also derive the following variation from the equation expenses). There is profit because income is greater than
above: expenses.
 5,000= 400 +800 +3,800

Income and expenses(or profit or loss) are closed to equity at the

end of each accounting period. Thus, the adjusted ending
balance of equity is computed as follows:

ASSETS= L IAB I L ITIES+E Q UITY+P R O FIT

Equity, beginning 800
Add: Income 10,000
Less: Expense (6,200)
Equity, ending 4,600

OR

Equity, beginning 800

Add: Profit 3,800
Equity,ending 4,600

Your basic accounting equation at the end of the accounting period is as follows:

ASSETS = LIABILITIES + EQUITY

5,000 = 400 + 4,600

Notice that regardless of its form or variation,the accounting equation (basic or

expanded) remains balanced.

APPL ICATI O NS O F THE ACC O UNTING E Q

 UATI O N

Case #1: TOTAL ASSETS

Solution:
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

Ca s e #2 : TOT A L L I A BI L ITI E S
 I f y o u h a v e t o t a l a s s e t s o f P2 ,000 a n d e q u it y o f P800, h ow m u c
h a r e y o u r t o t a l l i a b i l iti e s ?

S o l u ti o n :
A S S ETS= L I A BI L ITI E S+EQU ITY
2 ,000 = ? + 800

Va r i a ti o n # 1 o f t h e b a s i c e q u a ti o n :
L i a b i l iti e s + A s s e t s - E q u it y
? = 2 ,000 - 800

A n swe r :To t a l l i a b i l iti e s=( 2 ,000- 800)=1 , 200

Case #3: TOTAL EQUITY
 If you have total assets of P2,000 and total liabilities of P1,200, how much
is your total equity?

Solution:
ASSETS=LIABILITIES+ EQUITY
2,000 = 1,200 + ?

Variation #2 of basic equation

Equity+ Assets- Liabilities
?=2,000- 1,200

Answer: Total equity=(2,000-1,200)=800

CASE #4.1:Profit and loss
If you have a total income of P5,000 and total expenses of P2,000, how much is your profit(or loss)?

Solution:
Total income 5,000
Less: Total expenses (2,000)
Profit 3,000

CASE #4.2 Profit or loss

If you have a total income of P6,000 and total expenses of P11,000, how much is your profit(or loss)?

Solution:
Total income 6,000
Less: Total expenses (11,000)
Loss (5,000)
Case #5 INCOME
If you have total expenses of P2,000 and a profit of P3,000 how much is
your total income?

Solution:
Total income ?
Less: Total expenses (2,000)
Profit 3,000
The unknown (?) is simply "squeeze" which means to come up
with an unknown amount in a given formula by performing basic
arithmetic functions like adding, subtracting, multiplying, or
 dividing. When squeezing "upwards" (just like in the illustration
above), the arithmetic function is simply reversed. Thus, the P2,000
amount which is deducted when solving downwards is added when
"squeezing" upwards.

Answer: Total income=(3,000+2,000)=5,000

Total expenses (2,000)
When "squeezing" upwards, it is
Profit 3,000
always advisable to recheck your
"SQUEEZING" simplifies the
answer by squeezing downwards.
computation process because it
This is done as follows:
eliminates the need to make variations
of a formula. If we did not squeeze the
Rechecking: amount above, we would have made the
Total income 5,000 Less: following variation to the formula:
 Expenses=Profit
Original formula: Income Variation :Profit+Expenses=Income
CASE #6: Expenses

If you have a total income of P5,000 and a profit of P3,000, how much are your total expenses for the period?

Solution:
Total income 5,000
Less: Total expenses ?
Profit 3,000

Answer: Total expenses( 5,000-3,000)=2,000

Rechecking:

Total income 5,000

Less: Total expenses(2,000)
Profit 3,000
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?
Solution:
ASSETS=LIABILITIES+EQUITY+INCOME-EXPENSES
4,800=1,000+800+ ? - 2,000

Answer: Total Income= (4,800-1,000-800+2,000)=5,000

Rechecking:(Check out the equality of the accounting equation)

ASSETS=LIABILITIES+EQUITY+INCOME-EXPENSES
4,800=1,000+800+5,000 - 2,000
CASE #8: Expenses for the period
You have ending total assets of P4,800, ending total liabilities of P1,000, and beginning
equity of P800. If your total income for the period amounts to P5,000, how much are
your total expenses?
Solution:
ASSETS=LIABILITIES+EQUITY+INCOME-EXPENSES
4,800-1,000-800+5,000-?

Total expenses=(4,800-1,000-800+5,000)=2,000

Rechecking:
ASSETS=LIABILITIES+EQUITY+INCOME-EXPENSES
4,800=1,000+800+5,000 - 2,000
.
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 5,000
Add: Income 8,000
Less: Expenses (6,000)
Equity, ending 7,000

OR

Equity, beginning 5,000

Add/Less (8,000-6,000) 2,000
 Profit/loss
Euit,endin 7,000
Case 3 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 12,000
Add: Income 5,000
Less: Expenses (8,000)
Equity, ending 9,000

OR
Equity, beginning 12,000
Add/Loss (5,000-8,000) (3,000)
Equity,ending 9,000
Case # 10.1: Profit for the period
If your beginning equity is P5,000 while ending equity is P7,000, how much is your profit
or loss for the period?

Solution:
Equity, beginning 5,000
Add: Profit(or less:loss) ? (squeeze)
Equity, ending 7,000

Profit=(7,000-5,000)= 2,000

Rechecking:
Equity, beginning 5,000
Add: Profit(or less:loss) 2,000
Equity, ending 7,000
Case # 10.2 Loss for the period
If your beginning equity is P6,000 while ending equity is P2,000, how much is your profit
or loss for the period?

Solution:
Equity, beginning 6,000
Add: Profit(or less:loss) ?
Equity, ending 2,000

Loss=(2,000-6,000)= (4,000)

Rechecking:
Equity, beginning 6,000
 Add: Profit(or less:loss) (4,000)
Equity, ending 2,000
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:
ASSET=LIABILITIES+EQUITY
Beg. 10,000 = 7,000 +3,000
Decreased in liabilities/Profit (4,000) 5,000
End. ? = 3,000 +8,000

Answer:Ending total assets=(3,000 liabilities,end.+8,000 equity,end.)=11,000

Rechecking:(Ending balances)
ASSET=LIABILITIES+EQUITY
End. 11,000= 3,000 +8,000
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?

ASSET=LIABILITIES+EQUITY
Beg. Irrelevant(a)= Irrelevant +3,000
Profit Irrelevant 5,000
End.. ? = 4,000(b) +8,000

(a)Irrelevant: These amounts are not needed in computing for the requirement in the problem (b)
The phrase "decrease to P4,000" means that P4,000 is the ending balance of liabilities. Notice
the difference between the phrases "decreased by" (case #11 and (case #12).
Answer: Ending total assets=(4,000 liabilities,end.+8,000 equity,end)=12,000

Rechecking:(Ending balances)

ASSET=LIABILITIES+EQUITY
End. 12,000= 4,000 +8,000
CHAPTE R 3 SUMMAR Y:
The basic accounting equation is ASSET=LIABILITIES+EQUITY
ASSETS - are economic resources you control that have resulted from past events and can
provide you with economic benefits.
LIABILITIES-are the present obligations that have resulted from past events and can require
you to give up economic resources when settling them.
Equity is simply assets minus liabilities. Other terms for equity are "capital ","net assets", and
"net worth"
As s s e t s=li a b iliti e s+e q u ity+inc ome - e x p ens e s
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.
EXPENSES- are decreases in economic benefits during the period in the form of decreases in
assets, or decreases in assets, or increases in liabilities, that result in decreases in equity,
excluding those relating to distributions to the business owner.
If income is greater than expenses, the difference is profit
If income is less than expenses, the difference is loss.
Income and profit increase equity while expenses and loss decrease equity.
THE END