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The Accounting Equation

Bachelor of Science In Accountancy (University of San Jose - Recoletos)

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SENIOR HIGH SCHOOL DEPARTMENT

Corner P. Lopez & Magallanes Sts., Cebu City 6000 Philippines
Tel.No. (032) 253 7900 loc. 356

Subject: Fundamentals of Accountancy, Business and Management 1

Topic: The Accounting Equation
____________________________________________________________________________________________

Learning Competencies:
The learners shall be able to
• illustrate the accounting equation
• perform operations involving simple cases with the use of the accounting equation

Let’s LEARN: 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

For an economic resource to be considered an asset, you must control the right over the
economic benefits that the resource may produce. Control means you have the exclusive right to
enjoy those benefits and the ability to prevent others from enjoying those benefits.

Past Events

The control over an economic resource has 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 have taken 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 by withdrawing it or
spending it through electronic means.

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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; and
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 your 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 events 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:

1. 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 purchase price.

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Tel.No. (032) 253 7900 loc. 356

2. 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 you have already purchased and
received the cellphone; and 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).

3. 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 you earned taxable income; and 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).

4. 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 fee repair services for the goods you have already
sold because you have already taken an action by creating valid expectation on your customers
that you will provide free repair services; and 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 barbecue stand and have estimated that you will be needing ₱ 2,000 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 ₱ 800. You went to your Mama and asked
her to give you ₱ 1,200 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:

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Tel.No. (032) 253 7900 loc. 356

Assets = Liabilities + Equity

800 = 0 + 800

Notes:

 Your total assets are ₱ 800: the total 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 ₱ 800 (800 assets – 0 liabilities = 800 equity).

After a lengthy negotiation, Mr. Bombay agreed to lend you ₱ 1,200.

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

Assets = Liabilities + Equity

2,000 = 1,200 + 800

Notes:

 Your total assets are now ₱ 2,000: the total amount of economic resources that you
control (800 from Mr. Piggy plus 1,200 from Mr. Bombay).
 Of your total assets of ₱ 2,000:
- ₱ 1,200 represents your liability, the amount you are obligated to pay Mr. Bombay in the
future.
- ₱ 800 represents your equity (i.e. 2,000 assets – 1,200 liabilities).

 Liabilities represent the creditors’ claim, while equity represents the owner’s claim,
against the total assets of the business.
Notice that from Mr. Piggy to Bombay, the accounting equation remains balanced. Please
DO NOT forget this concept! 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 variations below:
Original form of the equation:

Assets = Liabilities + Equity

2,000 = 1,200 + 800

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Tel.No. (032) 253 7900 loc. 356

Variation # 1:

Assets - Liabilities = Equity

2,000 - 1,200 = 800

Variation # 2:

Assets - Equity = Liabilities

2,000 - 800 = 1,200

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/ REVENUES – are increases in economic benefits during the period in the form of
increase 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 (profit means ‘kita’ or ‘tubo’ in
Filipino).
 If income is less than expenses, the difference is loss (loss means ‘lugi’ in Filipino).
We can make another variation to the equation above as follows:

Assets = Liabilities + Equity + Profit/ - Loss

Profit increases equity while loss decreases equity.

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Tel.No. (032) 253 7900 loc. 356

Illustration 2: Continuation of Illustration 1 above

During the period, you earned income of ₱10,000 and incurred expenses of ₱6,200. At the end of
the period, your total assets increased from ₱2,000 to ₱5,000 and your total liabilities decreased
from ₱1,200 to ₱400.
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 ₱3,800 (₱10,000 income minus ₱6,200 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:

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SENIOR HIGH SCHOOL DEPARTMENT

Corner P. Lopez & Magallanes Sts., Cebu City 6000 Philippines
Tel.No. (032) 253 7900 loc. 356

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 ₱1,200 and equity of ₱800, how much is 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 ₱2,000 and equity of ₱800, how much is 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 ₱2,000 and total liabilities of ₱1,200, how much is your total equity?

Solution:
Assets = Liabilities + Equity
2,000 = 1,200 + ?

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Tel.No. (032) 253 7900 loc. 356

Variation # 2 of the basic equation:

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

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

Case # 4.1: Profit or loss

If you have total income of ₱5,000 and total expenses of ₱2,000, 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 total income of ₱6,000 and total expenses of ₱11,000, 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 ₱2,000 and a profit of ₱3,000, how much is your total income?
Solution:
Total Income ? (squeeze)
Less: Total Expenses (2,000)
Profit 3,000 (start)
The unknown (?) is simply “squeezed.” 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 ₱2,000 amount which is deducted when solving downwards
is added when “squeezing” upwards.
Answer: Total Income = (3,000 + 2,000) = 5,000

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Tel.No. (032) 253 7900 loc. 356

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 ₱5,000 and a profit of ₱3,000, how much is your total expenses for the
period?

Solution:
Total Income 5,000
Less: 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 ₱4,800, ending total liabilities of ₱1,000 and beginning* equity
is ₱800. If your total expenses for the period amount to ₱2,000, 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:

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Corner P. Lopez & Magallanes Sts., Cebu City 6000 Philippines
Tel.No. (032) 253 7900 loc. 356

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 ₱4,800, ending total liabilities of ₱1,000 and beginning equity of
₱800. If your total income for the period amounts to ₱5,000, how much is your total expenses?

Solution:

Assets = Liabilities + Equity + Income - Expenses

4,800 = 1,000 + 800 + 5,000 - ?

Answer: 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 ₱5,000. If your total income for the period is ₱8,000, while your total
expenses is ₱6,000, 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 (8,000-6,000) 2,000
Equity, ending 7,000

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Tel.No. (032) 253 7900 loc. 356

Case # 9.2: Ending equity

Your beginning equity is ₱12,000. If your total income for the period is ₱5,000, while your total
expenses is ₱8,000, 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 ₱5,000, while your ending equity is ₱7,000, how much is your profit or
loss for the period?

Solution:
Equity, beginning 5,000
Add/ Less: Profit or Loss ? (squeeze)
Equity, ending 7,000

Profit = (7,000 – 5,000) = 2,000

Rechecking:
Equity, beginning 5,000
Add/ Less: Profit or Loss 2,000
Equity, ending 7,000

Case # 10.2: Loss for the period

If your beginning equity is ₱6,000, while your ending equity is ₱2,000, how much is your profit or
loss for the period?

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Tel.No. (032) 253 7900 loc. 356

Solution:
Equity, beginning 6,000
Add/ Less: Profit or Loss ? (squeeze)
Equity, ending 2,000

Loss = (2,000 – 6,000) = (4,000)

Rechecking:
Equity, beginning 6,000
Add/ Less: Profit or Loss (4,000)
Equity, ending 2,000

Case # 11: Ending total assets

You had total assets, liabilities, and equity of ₱10,000, ₱7,000 and ₱3,000, respectively, at the
beginning of the period. During the period, your total liabilities decreased by ₱4,000, while your
profit was ₱5,000. How much is your ending total assets?

Solution:
Assets = Liabilities + Equity
Beginning 10,000 = 7,000 + 3,000
Decrease in liabilities/ (4,000) 5,000
profit
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

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Tel.No. (032) 253 7900 loc. 356

Summary:

 The basic accounting equation is Assets = Liabilities + Equity

 Assets are the economic resources you control that have resulted from past events and 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 assets, or increases in liabilities, that result in decreases in equity,
excluding those relating to distributions to the business owner/s.
 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.

DRILL 3.4

TRUE or FALSE (Quipper)

1. You acquired a car through an auto loan. The bank holds the registration papers of the car
until you have fully paid the loan. Right now, the car is not yet your asset even though you are
already using it because you don’t legally own the car yet.
2. Control of an asset refers to an entity’s exclusive right to enjoy the economic benefits from the
economic resource, including the entity’s ability to prevent others from enjoying those benefits.
3. Obtaining a loan increases both your assets and liabilities, but not your equity.
4. Equity is Assets plus liabilities.
5. Assets can arise from future events.
6. Income increases equity.
7. Expenses can result from an increase in assets.
8. Physical possession is a necessary condition in order for control of an asset to exist.
9. Profit decreases equity.
10. You bought a pair of shoes. You realized that the shoes don’t look good on you so you
decided not to use them anymore. However, you don’t want to give the shoes away or let others
use it. The shoes cannot be considered as your assets.

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SENIOR HIGH SCHOOL DEPARTMENT

Corner P. Lopez & Magallanes Sts., Cebu City 6000 Philippines
Tel.No. (032) 253 7900 loc. 356

ASSIGNMENT 3.4 (GDrive)

Problem Solving A. Compute and fill in the missing amounts in the Basic and Expanded
Accounting Equations.

BASIC ACCOUNTING EQUATION

ASSETS LIABILITIES EQUITY
1. 350,000 290,000
2. 530,000 270,000
3. 790,000 130,000
4. 820,000 320,000
5. 220,000 = 80,000 +
6. 480,000 290,000
7. 690,000 270,000
8. 790,000 130,000
9. 1,020,000 320,000
10. 2,200,000 890,000

EXPANDED ACCOUNTING EQUATION

ASSETS = LIABILITIES + EQUITY + INCOME - EXPENSES
1. 180,000 80,000 40,000 210,000
2. 940,000 280,000 140,000 380,000
3. 280,000 20,000 60,000 80,000
4. 360,000 70,000 180,000 60,000
5. 880,000 470,000 680,000 490,000
6. 290,000 110,000 20,000 240,000
7. 780,000 310,000 240,000 150,000
8. 980,000 120,000 600,000 190,000
9. 640,000 170,000 1,900,000 1,860,000
10. 880,000 470,000 680,000 490,000

Problem Solving B: Determine the effects of the transactions or events described below on the
basic accounting equation.

Example: You invested ₱20 cash from your personal savings to your business.
Answer:
ASSETS = LIABILITIES + EQUITY
20 0 20

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Corner P. Lopez & Magallanes Sts., Cebu City 6000 Philippines
Tel.No. (032) 253 7900 loc. 356

TRANSACTIONS ASSETS = LIABILITIES + EQUITY

1. You found
additional ₱100 in
your shoe. You also
invested this
amount to your
business.
2. Your business
obtained a loan of
₱2,000.
3. Your business
earned income of
₱4,500 during the
period. The income
did not affect your
liabilities.*
4. Your business
incurred expenses
of ₱800 during the
period. The
expenses did not
affect your
liabilities.*
5. Get the totals of
the assets, liabilities
and equity. Check if
the accounting
equation is
balanced.

*Hints:
- If you don’t know the effects of these transactions, go back to the definitions of income and expense. See what
else do these items affect other than liabilities.
- Show decreases in the elements of the accounting equation as negative values, i.e. amounts in parentheses.

References

Ong, F.L. Fundamentals of Accountancy, Business, and Management 1 for Senior High School. C & E
Publishing, Inc., 2017

Ferrer, R., and Millan, Z.V. Fundamentals of Accountancy, Business & Management Part 1. 3rd Edition,
Bandolin Enterprise, 2019

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