CHAPTER 3

THE ACCOUNTING EQUATION AND

DOUBLE-ENTRY SYSTEM

THE ACCOUNTING EQUATION

​The financial position of a business is grounded on the accounting

equation. This equation must always be equal or in balance all throughout
the accounting process. The left side of the equation is consisted of the
resources controlled by the entity, whereas the claims against those
resources are what composed the right side of the equation. The claims are
classified in to two, the creditor’s claim and owner’s claim.

Every entity may raise capital in two ways: by owner’s investment

and by obtaining credit. At the onset of the business’ legal life, the owner
may invest his own asset to the business. But as the demand for additional
capitalization exists, the owner, in the name of the business, may obtain
loans and other financing activities from creditors who are willing to lend
capital. Thus explain the two classifications of claims over resources.

To simplify, the equation can be written as:

Resources = Creditor’s claim + Owner’s claim

​

The resources mentioned above are most commonly referred to as

assets. On the other hand, the creditor’s claim are called liabilities.
Owner’s claim or equity is the residual interest in the assets of the entity
after deducting all its liabilities.

​ sing these accounting terminologies, we can simply inscribe the

U
equation as:

Assets = Liabilities + Equity

​

​
​Equity is affected by owner’s additional investment and
withdrawal. Equity is increased by investment and decreased by
withdrawal. Other than these two, any increase or decrease in equity can

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 be attributed to income or expense, respectively. Income increases equity
Expense decreases the same. Hence, we can elaborate the accounting
equation using this diagram:

Asset = Liabilities + Equity

Increased by:
Contributions and Income

Decreased by: Withdrawal

and Expenses

Assets, liabilities, equity, income and expenses are called elements

of financial statements as discussed in chapter 1. The items consisting
these elements are called accounts. Accounts are the tools used to store
accounting data and accumulate the amounts for similar transactions. It is
used to record the changes, as either increase or decrease, in the
accounting elements. The accounts used by the entity in recording
transactions are summarized as chart of accounts. Chart of accounts will
minimize confusion in the selection of account title to be used in an entry,
and would result to consistency.

Below are examples of assets, liabilities, equity, income and

expense accounts:

Assets:
1. Cash, which comprises cash on hand and demand deposits.
2. Cash equivalents, are short-term, highly liquid investments that are
readily convertible to known amounts of cash and which are
subject to an insignificant risk of changes in value.
3. Accounts receivable, are open accounts from the sale of goods or
services in the ordinary course of business.
4. Notes receivable, are receivables supported by a promissory note.
5. Inventories, which are assets held for sale in the ordinary course of
business; in the process of production for such sale; or in the form
of materials or supplies to be consumed in the production process
or in the rendering of services.
6. Prepaid expense, are future expense that are already paid in
advance.
7. Property, plant and equipment, are tangible items that are held for
use in the production or supply of goods or services , for rental to
others, or for administrative purposes, and are expected to be used
for more than one accounting period.
8. Equity securities, are those that represent ownership in a company
or rights to acquire ownership interests at an agreed-upon or
determinable price.
9. Debt securities, are instruments representing creditor relationship
with an enterprise.
10. Intangible asset, an identifiable, non-monetary asset without
physical substance.

Liabilities:
1. Accounts payable, or trade accounts, are liabilities arising from the

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 purchase of goods, materials or supplies on an open-charge
account basis.
2. Interest payable, refers to the obligation of a company for interest
already incurred but not yet paid.
3. Provision, are liabilities of uncertain timing or amount.
4. Unearned rent, amount received in advance from lessee for the use
of the asset in the future.
5. Note payable, an obligation arising from an unconditional promise
in writing by a debtor to another, engaging to pay on demand or at
a fixed determinable date, a sum certain in money.
6. Bonds payable, a liability arising from a formal unconditional
promise of a debtor, made under seal, to pay a specified sum of
money at a determinable future date, and to make periodic interest
at a stated rate until the principal sum is paid.
7. Mortgage payable, a liability of an owner of property to pay a loan
that is secured by a property.

Equity:
1. Dela Cruz, Capital, the equity or capital account of an owner over
an enterprise
2. Retained Earnings, is the accumulated profits and losses of an
enterprise from the time it started operations up to the current
period.

Income:
1. Service income, income earned after providing services to the
clients or customers.
2. Interest income, income earned from lending of money, computed
using a stated interest rate.
3. Rent income, income arising from the use of property.
4. Sales / Revenue, income arising from sale of goods in the normal
course of business.
5. Gain on sale or gain on disposal, the excess of the net selling price
over the carrying value of the asset disposed.

Expenses
1. Advertising expense, amount incurred in marketing or advertising a
product or service.
2. Cost of sales, the cost of services or products sold during the
current period.
3. Loss on sale, occurs when the carrying value of the asset disposed
exceed the net selling price.
4. Warranty expense, expense arising from the estimate of the repair
or service costs during a specified period if the products sold are
defective.
5. Salary expense, amount incurred to pay for the salaries of
employees during a specific period.

TRANSACTION ANALYSIS

It was mentioned earlier that the accounting equation must remain

equal all throughout the accounting process. Hence, one must observe this
rule in every transaction that occurs in the business. Below are the
possible effects of the changes in accounting elements to the accounting
equation.

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 Asset = Liability + Equity
Increase = Increase + No effect
Increase = No effect + Increase
Decrease = Decrease + No effect
Decrease = No effect + Decrease
Increase (Decrease) = No effect + No effect
No effect = Increase + Decrease
No effect = Decrease + Increase
No effect = Increase (Decrease) + No effect
No effect = No effect + Increase (Decrease)

Illustration: In January 2018, Dolores Company opened an accounting

services firm named Dolores & Associates. The following are the
transactions occurred in January 2018:

January 3
Dolores contributed cash of P100,000, land worth P400,000, and office
building worth P300,000.

Analysis: The assets of the business in form of cash, land and

building will increase, with corresponding increase in equity.

Asset = Liability + Equity

Cash P100,000
Land. 400,000 = No effect + Dolores, Capital P800,000
Building 300,000

January 10
Dolores borrowed P250,000 cash from Metrobank for use in business.

Analysis: The assets of the business in form of cash will increase

with corresponding increase in liability in form of loans payable.

Asset = Liability + Equity

Cash P250,000 = Loans Payable P250,000 + No effect

January 13
Dolores bought tables and chairs for P125,000 cash and office equipment
in exchange for P200,000 notes payable.

Analysis: The assets of the business in form furniture and

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 equipment will increase, with corresponding decrease in another
asset in form of cash and increase in liability in form of notes
payable.

Asset = Liability + Equity

Furniture P125,000
Equipment 200,000 = Notes payable P200,000 + No effect
Cash (125,000)

January 15
Dolores withdrew P10,000 from the business.

Analysis: The assets of the business in form cash will decrease,

with corresponding decrease in equity in form capital account.

Asset = Liability + Equity

Cash. (P10,000) = No effect + Dolores, Capital (P10,000)

January 20
Dolores paid advertising cost of P15,000 to market the services of the
firm.

Analysis: The assets of the business in form cash will decrease,

with corresponding decrease in equity in form of advertising
expense.

Asset = Liability + Equity

Cash. (P15,000) = No effect + Advertising expense (P15,000)

January 25
Dolores had its first customer. Dolores billed and collected from the
customer, P50,000

Analysis: The assets of the business in form cash will increase,

with corresponding increase in equity in form of service income.

Asset = Liability + Equity

Cash. P50,000 = No effect + Service income P50,000

​
January 28
Dolores paid 50% of the notes payable.

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 Analysis: The assets of the business in form cash will decrease,
with corresponding decrease in liability in form of notes payable.

Asset = Liability + Equity

Cash. (P100,000) = Notes payable (P100,000) + No effect

​ ​
January 29
Dolores paid 5,000 for water, electricity and telephone expenses.

Analysis: The assets of the business in form cash will decrease,

with corresponding decrease in equity in form of utilities expense.

Asset = Liability + Equity

Cash. (P5,000) = No effect + Utilities expense (P5,000)

January 31
Dolores paid the salary of her accounting staff in the amount of P15,000.

Analysis: The assets of the business in form cash will decrease,

with corresponding decrease in equity in form of salaries expense.

Asset = Liability + Equity

Cash. (P15,000) = No effect + Salaries expense (P15,000)

Note that the accounting equation was maintained all throughout

the foregoing transactions. In every transaction accounted for, the effects
on the left side of the equation (asset) were associated with same effects in
the right side of the equation (liability and equity).

If we summarize the total effects of these transactions, we will

have the following table:

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 The total assets had a balance of P1,155,000 (Cash of P130,000,
Land of P400,000, Building of P300,000, Furniture of P125,000 and
Equipment of P200,000) while total liabilities and equity also had the
same balance (liabilities: loans payable of P250,000 and notes payable of
P100,000; and equity: Dolores, Capital of P790,000, expense of P35,000
and income of P50,000).
​
I​ f Dolores &. Associates will prepare its financial statements for
January 2018, it will be prepared as follows:

Dolores & Associates

Statement of Profit or Loss
For the month ended January 31, 2018

Service income P 50,000

Less: Advertising expense P 15,000
Utilities expense 5,000
Salaries expense 15,000 35, 000
Profit P 15,000

Dolores & Associates

Statement of Changes in Equity
For the month ended January 31, 2018

Capital, 1/1/18 P800,000

Add: Profit for January 15,000
Less: Withdrawal 10,000
Capital, 1/31/18 P 805,000

Dolores & Associates

Statement of Financial Position
As of January 31, 2018

Assets Liabilities
Cash P 130,000 Notes payable P 100,000
Furniture 125,000 Loans payable 250,000
Equipment 200,000 Total liabilities 350,000
Building 300,000
Land 400,000 Equity

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 Dolores, Capital P 805,000

Total assets P 1,155,000 Total liabilities and equity P 1,155,000

THE DOUBLE-ENTRY SYSTEM

​The concept of double-entry system is based on the principle of

proportionality. It means that in every transaction throughout the
accounting process, the accounting equation must remain in balance. The
total effect to assets must have a corresponding total effect to liabilities or
equity or both. Although, some transactions only affect one side of the
equation, the balance of the whole equation is not affected.

In the double-entry system, a transaction is recorded with at least

one debit or one credit. Debit is the left side of the T account while credit
is the right side. T account is used to simplify the analysis of the increase
or decrease of an account and summarize the movement of such account in
a given period.

Debit Credit
(left) (right)

​The accounting equation can be mapped in the T account as

follows:

Debit Credit
Assets Liabilities and Equity

​Using the foregoing diagram, assets are placed in the debit side
while liabilities and equity are in the credit side, which determine their
normal balances. Normal balance of assets is debit while the normal
balance of liabilities and equity is credit. It is important to identify the
normal balance of the accounts since accounts are increased if placed in its
normal balance. Therefore, assets accounts are increased if debited and
decreased if credited. Needless to say, liabilities and equity accounts
are increased if credited and decreased if debited.

​Income increases equity, thus the rules on debit and credit for
equity also apply to income. On the other hand, expenses decrease equity
hence expenses are increased by debit and decreased by credit.

​To simplify, debit increases assets and expenses and decreases

liabilities, equity and income. Credit increases liabilities, equity and
income and decreases assets and expenses.

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 ​The table below summarizes the rules of debit and credit:

Element To increase To decrease

Asset debit credit
Liability credit debit
Equity credit debit
Income credit debit
Expense debit credit
​

​
​
Asset
Debit Credit
increase decrease

Debit Credit
(left) (right)

Liability
Debit Credit
decrease increase

Equity
Debit Credit
decrease increase

​
​
Income
Debit Credit
decrease increase

Expense
Debit Credit
increase decrease

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 ​

Using the transactions in Dolores & Associates, recording in T-

accounts will be done as follows:

January 3
Dolores contributed cash of P100,000, land worth P400,000, and office
building worth P300,000.

Analysis:
Account Element Change Action
Cash Asset Increase Debit
Land Asset Increase Debit
Building Asset Increase Debit
Dolores, Capital Equity Increase Credit

Therefore, the T-Accounts shall be prepared as follows:​

​
Cash
100,000

Land
400,000

Building
300,000

Dolores, Capital
500,000

Notice that the total amount debited of P800,000 is equal to the

total amount credited.

January 10
Dolores borrowed P250,000 cash from Metrobank for use in business.

Analysis:
Account Element Change Action
Cash Asset Increase Debit

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 Loan payable Liability Increase Credit

​
Cash
250,000

Loan payable
250,000

January 13
Dolores bought tables and chairs for P125,000 cash and office equipment
in exchange for P200,000 notes payable.

Analysis:
Account Element Change Action
Cash Asset Decrease Credit
Furniture Asset Increase Debit
Equipment Asset Increase Debit
Note payable Equity Increase Credit

Cash
125,000

Equipment
200,000

Furniture
125,000

Note payable
200,000

​
January 15
Dolores withdrew P10,000 from the business.

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 Analysis:
Account Element Change Action
Cash Asset Decrease Credit
Dolores, Capital Equity Decrease Debit

Cash
10,000

Dolores, Capital
10,000

January 20
Dolores paid advertising cost of P15,000 to market the services of the
firm.

Analysis:
Account Element Change Action
Cash Asset Decrease Credit
Advertising Expense Expense Increase Debit

​
​
Cash
15,000

Advertising expense
15,000

January 25
Dolores had its first customer. Dolores billed and collected from the
customer, P50,000.

Analysis:
Account Element Change Action
Cash Asset Increase Debit
Service Income Income Increase Credit

​
Cash
50,000

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 Service Income
50,000

January 28
Dolores paid 50% of the notes payable.

Analysis:
Account Element Change Action
Cash Asset Decrease Credit
Note payable Liability Decrease Debit

​
Cash
100,000

Note payable
100,000

January 29
Dolores paid 5,000 for water, electricity and telephone expenses.

Analysis:
Account Element Change Action
Cash Asset Decrease Credit
Utilities Expense Expense Increase Debit

​
Cash
5,000

Utilities expense
5,000

January 31
Dolores paid the salary of her accounting staff in the amount of P15,000.

Analysis:

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 Account Element Change Action
Cash Asset Decrease Credit
Salaries Expense Expense Increase Debit

​
Cash
15,000

Salaries expense
15,000

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