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THE ACCOUNTING EQUATION

Assets = Liabilities + Owner’s Equity (or Capital)

Assets must equal the sum of liabilities and owner’s equity. The equal sign in the equation
ensures balance of the movement in the three main accounts being used in accounting. The equal sign
also separates the left side (debit) from the right side (credit) of the equation.

DEFINITION OF AN ACCOUNT

The accounting equation “assets equal liabilities plus owner’s equity” perfectly captures the major
accounts. These major accounts, which also happen to be the main classification of accounts, are
assets, liabilities, and owner’s equity. Owner’s equity includes revenues and expenses.

ACCOUNT TITLE

Left side for debit Right side for credit

Movements in specific accounts are either debit or credit depending upon the account’s normal
balance. Asset accounts have normal balances of debit while liability accounts and owner’s equity
accounts have normal balances of credit. This is consistent with how they appear in the basic accounting
equation.

DEBIT CREDIT
(LEFT SIDE) (RIGHT SIDE)

Assets = Liabilities + Owner’s Equity


(or Capital)

MAJOR ACCOUNTS: DEFINITION, CLASSIFICATION, AND EXAMPLES

The major accounts in accounting are assets, liabilities, owner’s equity, revenues and expenses.
Though revenues and expenses are under owner’s equity account, they are shown separately because
they are the main income statement accounts.

ASSETS – are resources controlled by the business as a result of past transactions and events and from
which future economic benefits are expected to flow to the business. Simply put, these are anything of
value that is owned by the business.
Assets can be classified into two:

Current assets – are those reasonably expected to be realized in cash within one year from the reporting
date or the normal operating cycle, whichever is longer.

Non-current assets – if an asset cannot be classified as current.

If future economic benefits of the asset exceed one year, then the operating cycle of the business is the
basis for the asset classification.

Operating Cycle – is the average time it takes the business to turn the cash used in the business to cash
received from selling goods or rendering services.

Examples of asset accounts include:

1. CASH

- this includes cash on hand (bills, coins, checks, money orders, or bank drafts,) cash
deposited in bank (savings account, or checking account), and cash fund (petty cash fund, or
payroll fund) which are unrestricted in use. Cash equivalents are short-term, highly liquid
investment that are acquired three months before maturity or earlier.

2. Accounts Receivable

- This refers to open accounts which represent the amount of money owed by the customers
to the business. This arises from the business rendering services or selling goods to
customers.

3. Notes Receivable

- This represents the amount of money owed by the customer or debtor to the business
evidenced by a promissory note. A promissory note is written and signed promise to pay by
the maker to the payee a sum certain in money on demand at a specified future date.

4. Inventories

- This represents assets held for sale in the ordinary course of business, in the process of
production for sale or in the form of materials or supplies to be consumed in the production
process or in the rendering of services.

5. Unused Supplies

- This represents supplies which remain unused at the end of the accounting period.

6. Prepaid Rent

- This refers to an advance payment made by the business to cover for the future rental
payments.

7. Equipment
- This represents manual or automated machines used in the business and they include
photocopying equipment, computers, laptops, ring binders, laminating machines, delivery
vehicles, and vans, among others.

8. Furniture and Fixtures

- This represents assets such as tables, chairs, filling cabinets and display racks.

9. Building

- This refers to the physical structure owned and used by the business to conduct its business
operation.

10. Land

- This refers to the physical site owned by the business where the building is situated. It is not
subject to depreciation

11. Allowance for Doubtful Accounts

- This is a contra-asset or a valuation account which refers to the portion of accounts


receivable that is estimated to be uncollectible at the end of a particular accounting period.

12. Accumulated Depreciation

- This is a contra-asset or valuation account which refers to the aggregate portion of the total
cost of property, plant, and equipment that has been charged to depreciation expense.

LIABILITIES

- Are present obligation of an entity arising from past transactions or events, the settlement of
which is expected to result in an outflow from the business of resources embodying
economic benefits.

- Simply put, these represent claims against the assets of the business. These are what the
business owes.

Liabilities can be classified into two:

1. Current liabilities – are those reasonably expected to be settled by payment of cash, delivery of
goods or performance of service within its normal operating cycle or within one year from the
reporting date, whichever is longer.

2. Non-current liabilities – are obligations reasonably expected to be paid in cash beyond one year.

Examples of liability accounts include:

1. Accounts Payable – this refers to open accounts which represent the amount of money owed by
the business to creditors or suppliers.

2. Notes Payable – this represents the amount of money owed by the business to the supplier or
creditor evidenced by a promissory note.
3. Loan Payable – this represents the amount of money borrowed by the business from third party
creditors

4. Mortgage Payable – this represents the amount of money borrowed by the business from a bank
or a lending institutions which is secured by collateral.

5. Unearned Revenue – this represent cash collected by the business in advance for a service or
good that is yet to be rendered or delivered.

Revenues are the earnings arising from the main line of operations of the business. Revenues result
from rendering services or selling of goods.

Examples of revenue accounts include:

1. Service Revenue – this refers to the earnings made by any business that is into rendering
services. The term “revenue” is used and not “income” to distinguish that such an earning arises
form the main line of operations of the business.

2. INTEREST INCOME – this represent interests credited by the bank to the account of the business
arising from bank deposits. Notice that the term “income” was used since earning interests
from bank deposits is not the main line of operations of the business.

3. SALES – this represents the earnings made by any business that is into selling goods or
merchandise.

4. PROFESSIONAL FEES – this represents earning made by professionals or experts from rendering
services to their clients. Professionals include lawyers, doctors and certified public accountants,
among others. Thus, this can be considered as a revenue account or an expense account. to
distinguish between the two, a company’s chart of accounts can have both Professional Fees
Income and Professional Fees Expense.

EXPENSES

- Are the cost being incurred by the business in generating revenues.

Examples of cost and expenses accounts include:

1. UTILITIES EXPENSE – this refers to costs associated with the usage of electricity, water, and
communication for a particular accounting period.

2. SALARIES EXPENSE – this refers to costs incurred associated with the services rendered normally
by the permanent and full-time employees who are paid on a regular basis, usually monthly

3. WAGES EXPENSE – this refers to costs incurred associated with the services rendered normally
by contractual and temporary employees and workers who are paid on an hourly rate or based
on output
4. TAXES AND LICENSES EXPENSE – this represents costs incurred to register the business, to
acquire the right to operate and to settle taxes.

5. COST OF SALES – this refers to the cost of merchandise or goods that were sold during a
particular accounting period.

6. SUPPLIES EXPENSE – this refers to the amount of supplies that was used during a particular
accounting period.

7. DOUBTFUL ACCOUNTS EXPENSE – this refers to the amount of accounts receivable that is
estimated as uncollectible and is recognized as an expense in the current accounting period.

8. DEPRECIATION EXPENSE – this refers to the allocated portions of the cost of property plant and
equipment charged to expense in the current accounting period.

NORMAL BALANCES AND INCREASES AND DECREASES

Normal Increase Decrease


Balance Through Through
+ -
Assets Debit Debit Credit
Liabilities Credit Credit Debit

Owner’s equity:
 Owner, Capital Credit Credit Debit
 Owner, Drawing Debit Debit Credit

Revenues Credit Credit Debit


Expenses Debit Debit Credit

Contra-asset accounts:
 Allowance for Doubtful Accounts Credit Credit Debit
 Accumulated Depreciation Credit Credit Debit