CHAPTER III

THE ACCOUNTING EQUATION

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

ASSETS
- are the economic resources you control that have resulted from past events and can provide
you with economic benefits

CONTROL
- means you have the exclusive right to enjoy those benefits and the ability to prevent others
from enjoying those benefits

Example 1: Resource owned but not considered 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 right over the economic
benefits from it, even if you are the legal owner.

Example 2: Resource owned but considered an asset

You acquired a cellphone from a telecommunications company on a 2-year installment plan.
The agreement states that if you miss an installment payment, the telecommunications
company can get the cellphone back.
Analysis: Upon taking possession, the cellphone becomes your asset even if you do not actually
own it yet until you have fully paid the installment price. This is because you control the right
over the economic benefits of the cellphone through exclusive use.
PAST EVENTS
- The control over an economic resource have resulted from a past event or transaction.
Therefore, resources for which control is yet to be obtained 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 only after you have
purchased it and taken possession of 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 by withdrawing it or
spending it through electronic means.

ECONOMIC BENEFITS
- To be an asset, the economic resource must have the potential to provide you with economic
benefits in at least one circumstance. For example, the economic resource can be
a. Sold, leased, transferred, or exchanged 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 a liability

LIABILITIES
- are your present obligations that have resulted from past events and can require you to give
up economic resources when settling them.

OBLIGATION
- obligation means a 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.

GIVING UP OF ECONOMIC RESOURCES

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

PRESENT OBLIGATION AS A RESULT OF PAST EVENTS

- A present obligation exists as a result of past event if:
a. You have already obtained economic benefits or taken an action, and
b. As a consequence, you are required to transfer an economic resource.

Examples:

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
receive the cellphone, and therefore you are not required to pay for the purchase price.

You purchased a cellphone on credit. You took possession over the cellphone but have not
yet paid the purchase 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 for the purchase 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 expectation 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.

EQUITY
- 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 then 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 (800 assets – 0 liabilities = 800 equity).

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

 As of this point, your accounting equation is as follows:

Assets = Liabilities + 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 P1,200 from Mr. Bombay).

👉 Of your total assets P2,000:

a. P1,200 represents your liability, the amount you are obligated to pay Mr. Bombay in
the future.
b. P800 represents your equity (i.e., P2,000 assets – P1,200 liabilities).
  Liabilities represent the creditors’ claim, while equity represents the owner’s claim,
against the total assets of the business.
Notice that from Piggy to Bombay, the accounting equation remains balanced.
Please DO NOT forget this concept, my friend! The equality of the accounting equation must be
maintained in all the accounting processes of recording, classifying, and summarizing. If the
accounting equation doesn’t balance, there is something wrong!
As mentioned earlier, the accounting equation is basically an algebraic equation.
Therefore, we can make variations from it. Analyze the following variations:

Original form of the equation:

Assets = Liabilities + Equity

2,000 = 1,200 + 800

Variation #1:

Assets - Liabilities = Equity

2,000 - 1,200 = 800

Variation #2:

Assets - Liabilities = Equity

2,000 - 1,200 = 800

THE EXPANDED ACCOUNTING EQUATION

We can expand the basic accounting equation by including two more elements - income and
expenses. The expanded accounting equation shows all the financial statement elements. The
expanded accounting equation is as follows:

Assets = Liabilities + Equity + Income - Expenses

Notice that income is added while expenses are deducted in the equation. These are because
income increases equity while expenses decrease equity.
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 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.
 If income is less than expenses, the difference is loss.

We can make another variation to the equation above as follows:

Assets = Liabilities + Equity + Profit / - Loss

📖Profit increases equity while loss decreases equity.

Illustration 2: (Continuation of ‘Illustration 1’ above)

During the period, you earned income of P10,000 and incurred expenses of P6,200.
At the end of the period, your total assets increased from P2,000 to P5,000 and your total
liabilities decreased from P1,200 to P400.

 Your expanded accounting equation is as follows:

Assets = Liabilities + Equity + Income - Expenses

5,000 = 400 + 800* + 10,000 - 6,200

*This represents your equity from ‘Illustration 1’ above.

We can also derive the following variation from the equation above:

Assets + Expenses = Liabilities + Equity + Income

 5,000 + 6,200 = 400 + 800 + 10,000

Your profit for the period is P3,800 (P10,000 income minus P6,200 expenses). There is
profit because income is greater than expenses.

A variation of the expanded accounting equation is shown below:

Assets = Liabilities + Equity + Profit

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:

Equity, beginning 800

Add: Income 10,000
Less: Expenses (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.
APPLICATIONS OF THE ACCOUNTING EQUATION
Before we move on, let us master first how the accounting equation works. I encourage you to
diligently study the following drills:

Case #1: Total Assets

If you have total liabilities of P1,200 and equity of P800, how much are your total assets?

Solution:

Assets = Liabilities + Equity

? = 1,200 + 800

Answer: Total assets = (1,200 + 800) = 2,000

Case #2: Total liabilities

If you have total assets of P2,000 and equity of P800, how much are your total liabilities?

Solution:

Assets = Liabilities + Equity

2,000 = ? + 800

Variation #1 of the basic equation:

Liabilities = Assets - Equity

? = 2,000 - 800

Answer: Total liabilities = (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 + ?

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:
Total income: 6,000
Less: Total expenses (11,000)
Loss 5,000

📖In accounting, amounts in parentheses are negative amounts.

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 ? (squeeze)
Less: Total expenses (2,000)
 Profit 3,000 (start)

The unknown (‘?’) is simply “squeezes”. In accounting, to “squeeze” 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

When “squeezing” upwards, it is always advisable to recheck your answer by squeezing

downwards. this is done as follows:

Rechecking:
Total income 5,000 (start)
Less: Total expenses (2,000)
Profit 3,000 (squeeze)

“Squeezing” simplifies the computation process because it eliminates the need to make
variations of a formula. If we did not squeeze the amount above, we would have made the
following variation to the formula:
 Original formula: Income – Expenses = Profit
 Variation: Profit + Expenses = Income

Case #6: Expenses

If you have 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
Total expenses ?__ (squeeze)
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?
*(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

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

Assets = Liabilities + Equity + Income - 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 5,000
Add: Income 8,000
Less: Expenses (6,000)
Equity, ending 7,000

OR
Equity, beginning 5,000
Add/Less: Profit or Loss (8,000 – 2,000) 2,000
Equity, ending 7,000
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 12,000
Add: Income 5,000
Less: Expenses (8,000)
Equity, ending 9,000

OR
Equity, beginning 12,000
Add/Less: Profit or Loss (5,000 – 8,000) (3,000)
Equity, ending 9,000

Notice that profit is an addition to equity while loss is a deduction.

Case #10.1: Profit for the period

If your beginning equity is P5,000, while your ending equity 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 your ending equity is P6,000, while your 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) ? (squeeze)
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:

Assets = Liabilities + Equity

Beg. 10,000 = 7,000 + 3,000
Decrease 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)

Assets = 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?

Solution:

Assets = Liabilities + Equity

(a)
Beg. Irrelevant = Irrelevant + 3,000
Decrease in liabilities/ 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 “decreased to P4,000” means that P4,000 is the ending balance of liabilities.
Notice the difference between the phrases “decreased by” (Case #11) and “decreased to” (Case
#12).

Answer: Ending total assets = (4,000 liabilities, end. + 8,000 equity, end.) = 12,000

Rechecking: (Ending balances)

Assets = Liabilities + Equity

End. 12,000 = 4,000 + 8,000
CHAPTER 3 SUMMARY:

 The basic accounting equation is Assets = Liabilities + Equity.

 Assets are the economic resources you control that have resulted from past events and
can provide you with economic benefits.
 Liabilities are your present obligations that have resulted from past events and can
require you to give up economic resources when settling them.
 Equity is assets minus liabilities.
 The expanded accounting equation is:
Assets = Liabilities + Equity + Income – Expenses
 Income is increases in assets, or decreases in liabilities, resulting to increases in equity,
excluding those relating to investments by the business owner.
 Expenses are decreases in decreases in assets, or increases in liabilities, that result in
decreases in equity, excluding those relating to distributions to the business owner.
 Income less expenses equals profit or loss. If income is greater than expenses, there is
profit. If income is less than expenses, there is loss.
 Income and profit increase equity while expenses and loss decrease equity.
PROBLEM 4: FOR CLASSROOM DISCUSSION
The Basic Accounting Equation
1. Which of the following is incorrect regarding the basic accounting equation?
a. Essentially all aspects of financial accounting, from recording to communicating
financial information, involve the observance of the equality of the basic
accounting equation
b. The basic accounting equation is “Assets = Liabilities + Equity”
c. The basic accounting equation is an algebraic equation. Hence, other variations
or relationships can be derived from it.
d. The basic accounting equation is applicable only in basic accounting but not in
higher accounting.

Asset
2. Which of the following is not an essential factor in determining the existence of an
asset?
a. The presence of an economic resource that resulted from past events
b. Control over the economic resource
c. Potential of the economic resource to produce economic benefits for the entity
d. Present obligation
Liability
3. For a liability to exist, there must be a present obligation along with the other aspects of
a liability. A present obligation exists if
a. The entity has already obtained economic benefits or taken an action, and as a
consequence, the entity will or may have to transfer an economic resource that
it would not otherwise have had to transfer
b. The entity is required by law to pay either the government or another party
c. The entity has incurred a duty or responsibility, even if settling that duty or
responsibility would not in any way require the transfer of an economic resource
d. The entity expects to enter into a future transaction wherein the entity would be
required to pay cash or to transfer other resources
Equity
 4. Which of the following is incorrect concerning equity?
a. It is equal to Assets minus Liabilities
b. It is a residual amount
c. It represents the business owner’s claim against the total economic resources of
the business
d. It is different from capital, net assets or net worth
The Expanded Accounting Equation
5. Which of the following is not a correct variation of the expanded accounting equation?
a. Assets = Liabilities + Equity + Income – Expenses
b. Assets – Liabilities = Equity + Income – Expenses
c. Assets + Expenses = Liabilities + Equity + Income
d. Assets = Liabilities + Equity – Income + Expenses

Income and Expenses

6. Which of the following statements about income is incorrect?
a. It results from increases in assets or decreases in liabilities that result in
increases in equity, except those that pertain to the business owner’s
contributions to the business
b. It results to profit if it greater than expenses
c. It cannot result from decreases in assets or increases in liabilities
d. It results in decreases in equity

Applications of the Basic and Expanded Accounting Equations

7. An entity has total liabilities of P360,000 and total equity of P90,000. How much are the
total assets?
a. 270,000
b. 450,000
c. 360,000
d. None of these

8. An entity has total assets of P360,000 and total equity of P90,000. How much are the
total liabilities?
a. 270,000
b. 450,000
c. 360,000
d. None of these
9. An entity had a beginning equity of P123,000. If the total income for the period is
P59,000, while the total expenses are P81,000, how much is the ending balance of
equity?
a. 130,000
b. 110,000
c. 101,000
d. None of these

10. An entity had total liabilities of P340,000 at the end of the year. The beginning equity is
P280,000. If during the year, the entity earned income of P420,000 and incurred
expenses of P390,000, how much is the ending balance of total assets?
a. 560,000
b. 650,000
c. 780,000
d. 960,000