THE ACCOUNTING EQUATION

OBJECTIVES:

At the end of the session, the students are expected to:

• Be familiar with the accounting equation and its
elements
• Classify the elements of accounting equation
• Solve problems involving simple business
transactions with the use of accounting equation
Prove the equality of accounting equation
 THE ACCOUNTING EQUATION
The most basic tool of accounting is the
Accounting Equation. This equation presents the
resources controlled by the enterprise, the present
obligations of the enterprise and the residual
interest in the assets. It states that assets must
always equal labilities and owner’s equity. The
basic accounting model is:

ASSETS = LIABILITIES + OWNER’S EQUITY

(LEFT SIDE) (RIGHT SIDE)
ASSETS, LIABILITIES, AND OWNER’S EQUITY
Note that the assets are on the left side of the equation
opposite the liabilities and owner’s equity. This explains
why increases and decreases in assets are recorded in
the opposite manner as liabilities and owner’s equity are
recorded. The equation also explains why liabilities and
owner’s equity follow the same rules of debit and credit.
The logic of debiting and crediting is related to the
accounting equation. Transactions may require
additions to both sides (left and right sides), subtractions
from both sides (left and right sides), or an addition and
subtraction on the same side (left or right side), but in all
cases the equality must be maintained.
ASSETS, LIABILITIES, AND OWNER’S
EQUITY
It is customary to place “ Liabilities” before “Capital” in
the accounting equation because creditors have
preferential rights to the assets. The residual claim of the
owner or owners is sometimes given greater emphasis by
transposing liabilities to the other side of the equation,
yielding:

Asset - Liabilities = Owner’s Equity

Every business transaction affects the assets, liabilities

and/or capital of the business. However, the changes in
these items are such that the equality of two sides of the
accounting equation is always maintained.
 TABLE 1.1
DEBIT CREDIT

1. Increase in Assets 1. Decrease in Assets

2. Decrease in Liabilities 2. Increase in Liabilities

3. Decrease in Capital 3. Increase in Capital

a. Withdrawal by the
Owner a. Investment by the Owner

b. Increase in Expenses b. Decrease in Expenses

c. Decrease in Revenue c. Increase in Revenue

Debits and Credits

Assets ◆ Assets - Debits should exceed

Debit / Dr. Credit / Cr.
credits.

◆ Liabilities – Credits should

Normal Balance
exceed debits.
Chapter
3-23

◆ Normal balance is on the

increase side.
Liabilities
Debit / Dr. Credit / Cr.

Normal Balance

Chapter
3-24

SO 2 Define debits and credits and explain their use

in recording business transactions.
Debits and Credits

Revenue ◆ Purpose of earning revenues is to

Debit / Dr. Credit / Cr.
benefit the owner(s).

◆ Effect of debits and credits on

Normal Balance
revenue accounts is the same as
Chapter
3-26 their effect on Owner’s Capital.

◆ Expenses have the opposite effect:

Expense
Debit / Dr. Credit / Cr.
expenses decrease owner’s equity.

Normal Balance

Chapter
3-27

SO 2 Define debits and credits and explain their use

in recording business transactions.
 Debits/Credits Rules
Liabilities
Debit / Dr. Credit / Cr.
Normal Normal
Balance Balance
Debit Credit Normal Balance

Assets Chapter
3-24

Owners’ Equity
Debit / Dr. Credit / Cr.
Debit / Dr. Credit / Cr.

Normal Balance
Normal Balance

Chapter
3-23

Expense Chapter
3-25
Revenue
Debit / Dr. Credit / Cr.
Debit / Dr. Credit / Cr.

Normal Balance
Normal Balance

Chapter
3-27 Chapter
3-26

SO 2
Debits and Credits

Owner’s Equity ◆ Owner’s investments and

Debit / Dr. Credit / Cr.
revenues increase owner’s equity
(credit).
Normal Balance
◆ Owner’s drawings and expenses
Chapter
3-25 decrease owner’s equity (debit).

Owner’s Capital Owner’s Drawing

Debit / Dr. Credit / Cr. Debit / Dr. Credit / Cr.

Normal Balance Normal Balance

Chapter Chapter
3-25 3-23

SO 2 Define debits and credits and explain their use

in recording business transactions.
 Debit Credit Rule

ASSETS = LIABILITIES + O/EQUITY

Dr. Cr.
Asset + -
Liability - +
Owner’s equity - +
 Debits/Credits Rules

Balance Sheet Income Statement

Asset = Liability + Equity Revenue - Expense =

Debit

Credit

SO 2 Define debits and credits and explain their use

in recording business transactions.
Debits/Credits Rules

Question
Debits:

a. increase both assets and liabilities.

b. decrease both assets and liabilities.

c. increase assets and decrease liabilities.

d. decrease assets and increase liabilities.

SO 2 Define debits and credits and explain their use

in recording business transactions.
Debits/Credits Rules

Question
Accounts that normally have debit balances are:

a. assets, expenses, and revenues.

b. assets, expenses, and owner’s capital.

c. assets, liabilities, and owner’s drawings.

d. assets, owner’s drawings, and expenses.

SO 2 Define debits and credits and explain their use

in recording business transactions.
 Summary of Debits/Credits Rules

Relationship among the assets, liabilities and owner’s

equity of a business:
Illustration 2-11
Basic
Assets = Liabilities + Owner’s Equity
Equation

Expanded
Basic
Equation

The equation must be in balance after every transaction.

For every Debit there must be a Credit.

SO 2 Define debits and credits and explain their use

in recording business transactions.
 TRANSACTIONS AND THE ACCOUNTING
EQUATION
All business transactions, from the simplest to the most
complex, can be stated in terms of the resulting change in
the three basic elements of the accounting equation. Before
a transaction can be recorded in the book of accounts, it
must be analyzed into its debit and credit elements. The
following questions will be helpful in analyzing a business
transaction;

0 Which item (items) is/are affected – Assets, Liabilities,

Capital?
0 How is each item affected – it is increased or decreased?
0 According to the rules of debit and credit, is the increase or
the decrease in the item to be debited or credited?
0 What account titles should be used to record the debit or
credit item?
 DOUBLE ENTRY BOOKKEEPING

Every business transaction has two-fold effect

on the assets, liabilities, and/or capital of the
business. For every debit element, there is a
corresponding credit element. The money values
of these two elements are equal. The manner of
recording both the debit and credit elements of
each transaction is referred to as double-entry
bookkeeping. The double-entry bookkeeping is
preferred because it generally result in more
accurate accounting records and statements.
Moreover, it affords numerous checks and
safeguard which reduce to a minimum the
chances of loss through intentional or
unintentional errors committed by personnel.
 DOUBLE ENTRY BOOKKEEPING

The effect of these changes on the accounting equation

can be demonstrated by studying some typical transactions
using the analysis sheet as follows: