LESSON 3

THE ACCOUNTING EQUATION

THE ACCOUNTING EQUATION ASSETS = LIABILITIES + CAPITAL

 The value of all the assets of a firm equals the combined total value of the financial claims of the creditors (liability) and the claims of the owner (owner s equity)  The equation records business transactions in a logical and orderly way that shows business impact on the company s assets, liabilities and owner s equity  The accounting equation must always be balanced, i.e., the total amount of assets should always be equal to the sum of the liabilities and capital.  Any change in one part of the equation must always be accompanied by an equal change in the other part of the equation  Another way of presenting the basic accounting equation: Assets - Liabilities = Capital y y This form of equation stresses the importance of creditors. The owner s rights to the assets of the business are determined by first subtracting the rights of the creditors The creditors have first claims to assets

RECORDING BUSINESS TRANSACTIONS USING THE ACCOUNTING EQUATION The following transactions of JAM Travel & Tours took place during the first month of its operations January, 2010 : 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Julie A. Mendoza put up a travel agency, JAM Travel & Tours, with initial capital investment of P200,000. Paid office rental for 3 months, P60,000. Bought office supplies for cash, P5,000. Bought office equipment from IS Philippines on account, P40,000. Paid P10,000 to IS Philippines as partial payment of the debt in transaction no. 4. Received P20,000 as payment for rendering services to various customers. The business determines that it has used up P2,000 of the supplies J.A.Mendoza withdrew P1,000 from the business for her personal use. Paid the following expenses incurred during the period: salaries of office staff = P16,000 and utilities expense = P 12,000 When the account or debt due to IS Philippines amounting to P30,000 fell due, J.A. Mendoza was not able to pay cash. She issued instead a promissory note to the same amount due in 60 days to IS Philippines. Received the bill from Maynilad for water consumed during the month, P1,000. The business will pay the bill next week

11.

The following table presents an analysis of the above transactions

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NO TRANSACTIONS 1 JuJulie A. Mendoza put up travel agency, JAM Travel & Tours, with initial capital investment of P200,000. 2 ANALYSIS EFFECT There are two items affected: Cash, Increase in Asset which was increased by = Increase in P200,000 and Capital, which was Capital increased by the same amount Decrease Asset Decrease Capital in = in

Paid office rental for 3 Cost of goods or services needed in months, P60,000. business operations is recorded as expense which have a negative effect on capital. The asset cash was reduced because of the payment of expenses. The owner s capital was also reduced 3 g Bought office supplies for J. A Mendoza is substituting one cash, P5,000. asset with another asset. She is receiving (+) the asset supplies and paying out (-) the asset cash 4 Bought office equipment She is receiving the asset equipment from IS Philippines on but is not paying for it with cash, account, P40,000. since the transaction is on credit. The increase in asset is offset by an increase in liability 5 Paid P10,000 to IS The asset cash was reduced by the Philippines as partial amount paid to IS Philippines. The payment of the debt in claim of the creditor was also transaction no. 4. reduced 6 c Received P20,000 as payment Cash received from customers in for rendering services to exchange for firm s services or various customers. products is recorded as income. Revenue increases the assets of the business and also the capital of the owner 7 The business determines The business has P3,000 of the asset that it has used up P2,000 of supplies left and that P2,000 have the supplies been consumed or used up in doing business. Consumed supplies are recorded as expenses which are deducted from capital 8 J.A.Mendoza withdrew Cash withdrawal of the owner are P1,000 from the business not expenses incurred to produce for her personal use. revenue. This results in reduction not only in cash but also in the capital of the owner

Increase in one Asset = Decrease in another Asset Increase in Asset = Increase in Liability

Decrease Asset Decrease Liability

in = in

Increase in Asset = Increase in Capital

Decrease Asset Decrease Capital

in = in

Decrease Asset Decrease Capital

in = in

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NO 9 TRANSACTIONS Paid the following expenses incurred during the period: salaries of office staff =P16,000 and utilities expense = P12,000 ANALYSIS Cost of goods or services needed in business operations is recorded as expense which have a negative effect on capital. The asset cash was reduced because of the payment of expenses. The owner s capital was also reduced This transaction simply changes the type of debt to IS Philippines from Accounts Payable to Notes Payable, which is evidenced by a promissory note EFFECT Decrease Asset Decrease Capital

in = in

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When the account or debt due to IS Philippines amounting to P30,000 fell due, J.A. Mendoza was not able to pay cash. She issued instead a promissory note to the same amount due in 60 days to IS Philippines Received the bill from Maynilad for water consumption for the month. The business will pay the bill next week.

Decrease in one form of Liability = Increase in another form of Liability

Under the accrual method of accounting, The cost of water used by the business is recorded as expense even if it is not yet paid. Expense decrease capital. Since the amount is not yet paid, it is recorded as liability

Increase Liability Decrease Capital

in = in

The above transactions will be recorded using the accounting equation as follows:
NO ASSETS CASH 1 2 Bal 3 Bal 4 Bal 5 Bal 6 Bal 7 135,000 - 10,000 125,000 + 20,000 145,000 + 5,000 - 2,000 + 40,000 = 30,000 + + 5,000 + 40,000 + 5,000 + 200,000 -60,000 140,000 -5,000 135,000 + + 5,000 5,000 40,000 40,000 = = = = = 40,000 40,000 - 10,000 30,000 + 140,000 + 20,000 160,000 2,000 + 140,000 140,000 = + SUPPLIES + EQPT. = = = ACCTS PAYABLE LIABILITIES + NOTES PAYABLE + + CAPITAL J, TORRES CAPITAL 200,000 60,000 140,000

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Bal 8 Bal 9 Bal 10 Bal 11 Bal -

145,000 1,000 144,000 -28,000 116,000 116,000 116,000

3,000

40,000

30,000

+ -

158,000 1,000 157,000 28,000 129,000 129,000 -1,000 128,000

+ + + +

3,000 3,000 3,000 3,000

+ + + +

40,000 40,000 40,000 40,000

= = = = =

30,000 30,000 -30,000 1,000 1,000 + 30,000

+ + + 30,000 30,000 + +

TOTAL ASSETS 159,000

= =

TOTAL EQUITIES 159,000

SUMMARY OF EFFECTS OF TRANSACTIONS IN THE ACCOUNTING EQUATION 1. Increase in Assets = Increase in Capital 2. Increase in Assets = Increase in Liabilities 3. Increase in one form of Asset = Decrease in another form of Asset 4. Decrease in Asset = Decrease in Capital 5. Decrease in Asset = Decrease in Liability 6. Increase in one form of Liability = Decrease in another form of Liability 7. Increase in Liability = Decrease in Capital

EXPANDED ACCOUNTING EQUATION ASSETS = LIABILITIES + CAPITAL + INCOME EXPENSES

The expanded equation separates income and expenses from capital account. Hence, only the following transactions will be recorded under the capital account column:

a. Original investment of the owner b. Additional investment of the owner c. Withdrawal of the owner
Using the expanded equation, the transactions of JAM Travel and Tours, given on page 1, may be written as follows:

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NO CASH +

ASSETS

==

LIABILITIES

CAPITAL

+ INCOME - EXPENSES

SUPPLIES

EQPT.

ACCTS PAYABLE

NOTES PAYABLE

J, A.M. CAPITAL

Fees +Income Expenses

1 2 Bal 3 Bal 4 Bal 5 Bal 6 Bal 7 Bal 8 Bal 9 Bal 10 Bal 11 Bal

200,000 -60,000 140,000 -5,000 135,000 + + 5,000 5,000 40,000 135,000 - 10,000 125,000 + 20,000 145,000 + 5,000 - 2,000 145,000 1,000 144,000 -28,000 116,000 116,000 + + 3,000 3,000 + + 40,000 40,000 + 3,000 + 40,000 + 3,000 + 40,000 + 40,000 + 5,000 + 40,000 + 5,000 + 40,000

= = = = = = = = = = = = = = = = = = 1,000 30,000 - 30,000 + 30,000 30,000 + + 30,000 + 30,000 + 30,000 + 40,000 40,000 - 10,000 30,000 + + -

200,000 200,000 60,000 60,000

200,000

60,000

200,000

60,000

200,000 + 20,000 200,000

60,000

+ 20,000 - 60,000 2,000 62,000

200,000 - 1,000 199,000

+ 20,000 -

+ 20,000 - 62,000 - 28,000

199,000 199,000

+ 20,000 - 90,000 + 20,000 - 90,000 - 1,000 + 20,000 - 91,000

116,000

3,000

40,000

1,000

30,000

199,000

TOTAL ASSETS = TOTAL EQUITIES 159,000 = 159,000

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FINANCIAL STATEMENTS After recording and classifying the transactions, the summarizing function is done by preparing the following simple financial statements of Jam Travel &Tours :

1. INCOME STATEMENT
Jam Travel & Tours Income Statement For the month ended January 31, 2010 Fees Income Less: Expenses Rent Expense Supplies Expense Salaries Expense Utilities Expense Net Loss P 20, 000 P60,000 2,000 16,000 13,000

P 91,000 P(71,000)

2. BALANCE SHEET
Jam Travel & Tours Balance Sheet January 31, 2010 Assets Liabilities and Capital Liabilities: Accounts Payable Notes Payable Total Liabilities Capital J.A. Mendoza, Capital Total Liabilities and Capital

Cash Supplies Equipment

P116,000 3,000 40,000

P 1,000 30,000 P31,000

Total Assets

P159,000

P 128,000 P159,000

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3. STATEMENT OF CHANGES IN OWNER S EQUITY JAM Travel & Tours Statement of Changes in Owner s Equity For the Month Ended, January 31, 20090 J. A. Mendoza, Capital January 1, 2010 Less: J.A. Mendoza, Drawing Net investment Less: Net Loss J.A. Mendoza, Capital January 31, 2010 P200,000 1,000 P199,000 71,000 P128,000

4. CASH FLOW STATEMENT JAM Travel & Tours Statement of Cash Flows For the Month Ended January 31, 2010 Cash flows from operating activities Cash collections from customers Cash paid for operating expenses Purchase of supplies Cash used in investing activities Partial payment for equipment Cash flow from financing activities Investment of J. A. Mendoza Withdrawal for personal use Net Increase in the cash balance Cash balance January 1 Cash balance January 31

P 20,000 (88,000) ( 5,000)

P (73,000)

P (10,000)

P 200,000 (1,000)

P199,000 P116.000 ___0 P116,000

Note: The cash balance at the end of the month of January (P116,000) per Statement of Cash Flows is the same as cash balance per balance sheet.

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Presented below is the supporting computations for the cash flows:

a. Cash collection from customer (Trans. No. 6) b. Cash paid for operating expenses:
Rent expense (Trans. No. 2) Salaries expense (Trans. No. 9) Utilities expense (Trans.No. 9) Purchase of supplies (Trans. No.3) P60,000 .. 16,000 . 12,000 ..

. P 20,000

88,000 5,000

c. Cash used in investing activities

Partial payment of liability on the purchase of equipment .. P10,000

d. Investment of J. A. Mendoza (Trans. No. 1) e. Withdrawal of J.A. Mendoza (Trans. No. 8)

P 200,000 . P 1,000

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