ACT1101 FAR EASTERN UNIVERSITY PROF.

BERNADETTE RAMOS

The Basic Accounting Equation

Assets = Liabilities + Owner’s Equity

The basic tool of accounting is the accounting equation. It measures the resources of a
business and the claims (creditor’s equity and owner’s equity) to those resources.

Assets and Liabilities (Layman definition other than those as defined in the framework)

Assets are economic resources that are expected to benefit the business in the future.
Eg Cash, merchandise inventory, furniture, and land are assets.

Liabilities are debts payable to creditors.

Examples include Accounts Payable, Notes Payable and Salary Payable.

The owners’ claims to the assets of the business are called owners’ equity. Owner’s
equity or capital is the amount invested by the owner of the entity. This is affected by
Revenues & Expenses.
Revenues are increases in capital from delivering goods or services to customers. For
example, entity’s receipt of cash from a customer for services brings in revenue and
increases the business’s capital. Expenses are the decreases in capital that result from
operations. For example, the wages that the business pays to employees is an expense
and decreases capital.
When revenues exceed expenses, the result of operations is a profit. When expenses
exceed revenues, the result is a loss.

After earning profit, the owner may withdraw all or portion of the profit, the fourth type of
transaction that affects capital. Drawing or Withdrawals are distributions to owners of
assets (usually cash) generated by profit.

There are relatively few types of revenue, including:

• Sales revenue. Company earns sales revenue by selling items to customers.

• Service revenue. Company earns service revenue by rendering services.
• Interest revenue. Interest revenue is earned on bank deposits and on money
lent out to others.
• Dividend revenue. Dividend revenue is earned on investments in the stock of
other corporations.

Expenses decrease owners’ equity by using up assets or increasing liabilities in order

to deliver goods or services to customers. Businesses have lots of expenses,
including:
• Rent expense
• Salary expense for employees
• Advertising expense
• Utilities expense for water, electricity, and gas
ACT1101 FAR EASTERN UNIVERSITY PROF. BERNADETTE RAMOS

• Insurance expense
• Supplies expense for supplies used up
• Interest expense on loans payable
• Property tax expense

With the discussion of owner’s equity accounts, we can expand the basic accounting
equation as

Assets = Liabilities + Capital – Drawing + Income - Expenses

Accounting for Business Transactions

Accounting is based on actual transactions. A transaction is any event that affects the
financial position of the business and can be measured reliably.

To illustrate accounting for a business, let’s assume the following transactions for the
company.

Transaction 1: Initial investment made by the owner is P1,000,000.

Assets Liabilit Owner’s Equity

ies
Cash A Suppli La ‘ AP ‘ Capital ‘ Drawi ' Inco - Expen
R es nd = + - ng + me ses
1,000, 1,000,
000 000

Keep in mind that we are doing the accounting for the business. We are not accounting
for the owner.
View all transactions, and do all the accounting, from the perspective of the business—
not from the viewpoint of its owners. This same idea applies throughout accounting.

Transaction 2 Purchase of land

Company purchases land for an office location, paying cash of P400,000
Assets Liabilit Owner’s Equity
ies
Cash A Suppl Land ‘ AP ‘ Capita ‘ Drawi ' Inco - Expen
R ies = + l - ng + me ses
1,000, 1,000,
000 000
(400,0 400,0
00) 00

The cash purchase of land increases one asset, Land, and decreases another asset,
Cash.
ACT1101 FAR EASTERN UNIVERSITY PROF. BERNADETTE RAMOS

Transaction 3: Purchase of Office Supplies

The company buys stationery and other office supplies, agreeing to pay P500 within 30
days. This transaction increases both the assets and the liabilities of the business, as
follows:
Assets Liabilit Owner’s Equity
ies
Cash A Suppl Land ‘ AP ‘ Capita ‘ Drawi ' Inco - Expen
R ies = + l - ng + me ses
1,000, 1,000,
000 000
(400,0 400,0
00) 00
500 500

Office Supplies is an asset, not an expense, because the supplies can be used in the
future. The liability created by this transaction is an account payable. A payable is always
a liability.

Transaction 4: Earning of Service Revenue

The company earns service revenue by providing services for clients. Company earns
P15,000 revenue and collects this amount in cash. The effect on the accounting equation
is an increase in Cash and an increase in Income, as follows:

Assets Liabilit Owner’s Equity

ies
Cash A Suppl Land ‘ AP ‘ Capita ‘ Draw ' Inco - Expen
R ies = + l - ing + me ses
1,000, 1,000,
000 000
(400,0 400,
00) 000
500 500
15,000 15,0
0 000

A revenue transaction grows the business, as shown by the increases in assets and
Owners’ Equity (Income).

Transaction 5: Earning of Service Revenue on Account

The company performs service for clients who do not pay immediately. Company
receives the clients’ promises to pay P30,000 within one month. This promise is an asset,
an account receivable, because the company expects to collect the cash in the future.

Assets Liabili Owner’s Equity

ties
Cash AR Supp Land ‘ AP ‘ Capita ‘ Draw ' Inco - Expen
ACT1101 FAR EASTERN UNIVERSITY PROF. BERNADETTE RAMOS

lies = + l - ing + me ses

1,000, 1,000,
000 000
(400,0 400,
00) 000
500 500
15,00 15,0
0 000
30,0 30,0
000 00

Transaction 6: Payment of Expenses

During the month, the company pays 23,0,00 in cash expenses: rent of mobile office,
P10,000; employee salary, P12,000; and utilities, P1,000. The effects on the accounting
equation are:
Assets Liabil Owner’s Equity
ities
Cash AR Sup Lan ‘ AP ‘ Capit ‘ Dra ' Inco - Expe
plies d = + al - wing + me nses
1,000 1,000
,000 ,000
(400, 400,
000) 000
500 500
15,00 15,0
0 000
30,0 30,0
000 00
(23,0 (10,0 Rent
00) 00) expe
nse
(12,0 Sala
00) ries
Expe
nse
(1,00 Utiliti
0) es
Expe
nse

Expenses have the opposite effect of revenues. Expenses decreased balances of assets
and owner’s equity (Expenses). Each expense should be recorded separately.
ACT1101 FAR EASTERN UNIVERSITY PROF. BERNADETTE RAMOS

Transaction 7: Payment on Account

Company pays P500 to the store from which it purchased supplies in transaction3. The
effect on the accounting equation is a decrease in Cash and a decrease in Accounts
Payable, as shown here:

=
sets Liabil Owner’s Equity
ities
Cash AR Sup Lan ‘ AP ‘ Capit ‘ Dra ' Inco - Expe
plies d = + al - wing + me nses
1,000 1,000
,000 ,000
(400, 400,
000) 000
500 500
15,00 15,0
0 000
30,0 30,0
000 00
(23,0 (10,0 Rent
00) 00) expe
nse
(12,0 Sala
00) ries
Expe
nse
(1,00 Utiliti
ACT1101 FAR EASTERN UNIVERSITY PROF. BERNADETTE RAMOS

0) es
Expe
nse
(500) (500)

Transaction 8: Personal Transaction

The owner bought furniture for her home at a cost of P40,000, paying cash from personal
funds. This event is not a transaction of the company. It has no effect on the business
and, therefore, is not recorded by the business. This illustrates the entity concept.

Transaction 9: Collection on Account

In transaction 5, company performed services for a client on account. The business
now collects it.
Assets Liabil Owner’s Equity
ities
Cash AR Sup Lan ‘ AP ‘ Capit ‘ Dra ' Inco - Expe
plies d = + al - wing + me nses
1,000 1,000
,000 ,000
(400, 400,
000) 000
500 500
15,00 15,0
0 000
30,0 30,0
000 00
(23,0 (10,0 Rent
00) 00) expe
nse
(12,0 Sala
00) ries
Expe
nse
(1,00 Utiliti
0) es
Expe
nse
(500) (500)
30,00 (30,
0 000)

Transaction 10: Withdrawals

Unlike in transaction 8, the owner withdrew P100,000 from the business and pays her
personal debts.
Assets Liabil Owner’s Equity
ities
ACT1101 FAR EASTERN UNIVERSITY PROF. BERNADETTE RAMOS

Cash AR Sup Lan ‘ AP ‘ Capit ‘ Draw ' Inco - Expe

plies d = + al - ing + me nses
1,000 1,000
,000 ,000
(400, 400,
000) 000
500 500
15,00 15,0
0 000
30,0 30,0
000 00
(23,0 (10,0 Rent
00) 00) expe
nse
(12,0 Sala
00) ries
Exp
ense
(1,00 Utiliti
0) es
Exp
ense
(500) (500)
30,00 (30,
0 000)
(100, (100,
000) 000)
The effect of this transaction is decrease in asset (cash) and decrease in owner’s equity
(drawing)

To summarize the transactions of the company:

1. Investment of the owner, P1,000,000
2. Purchased land for cash, P400,000
3. Bought supplies on credit, P500
4. Rendered services for cash P15,000
5. Performed services on account, P30,000
6. Paid rent of mobile office, P10,000; salaries, P12,0000; and utilities,
P1,000
7. Paid the supplies purchased
8. Bought furniture for the owner using her personal funds.(not recorded,
personal transaction)
9. Collection of accounts receivable, P30,000.
10. Withdrawal of P100,000 from the business funds.

We have recorded the above transactions in the expanded accounting equation.

ACT1101 FAR EASTERN UNIVERSITY PROF. BERNADETTE RAMOS

Liabil
Assets Owner’s Equity
ities
Sup Lan ‘ ‘ Capit ‘ Draw ' Inco Expe
Cash AR AP -
plies d = + al - ing + me nses
1,000 ‘ 1,000
,000 = ,000
-
400, ‘
400,0
000 =
00
‘
500 500
=
15,00 ‘ 15,0
0 = 00
30, ‘ 30,0
000 = 00
- - Rent
‘
23,00 10,00 expe
=
0 0 nse
Salar
-
‘ ies
12,00
= Expe
0
nse
Utiliti
‘ - es
= 1,000 Expe
nse
‘
-500 -500
=
-
30,00 ‘
30,
0 =
000
- -
‘
100,0 100,
=
00 000
- -
‘ ‘ ‘ '
521,5 400, 1,000 100, 45,0 - 23,00
= + - +
00 0 500 000 0 ,000 000 00 0
922, ‘ ‘ 922,0
000 = 0 + 00
922 ‘
000 = 922,000

Take note that as you record transactions, the equality of the equation is always
maintained.
ACT1101 FAR EASTERN UNIVERSITY PROF. BERNADETTE RAMOS

The Financial Statements

After analyzing transactions, we want to see the overall results. We look now at the
financial statements discussed in the preceding section. The financial statements
summarize the transaction data into a form that’s useful for decision making. The financial
statements are the:
• Statement of comprehensive income – composed of profit or loss statement
(income statement) and other comprehensive income
• Statement of changes in equity
• Statement of financial position (balance sheet)
• Statement of cash flows

Income Statement
The income statement presents a summary of an entity’s revenues and expenses for a
period of time, such as a month or a year. The income statement, is also called the
profit of loss statement. Profit (total income greater than total expenses) or Loss (total
expenses greater than total income).

Statement of Changes in Equity

The statement of changes in equity shows the changes in capital during a time
period, such as a month or a year. The capital is increased by additional investments,
increased by profit or decreased by loss and drawing.

Statement of Financial Position

Or balance sheet lists the entity’s assets, liabilities, and owner’s equity as of a specific
date, usually the end of a month or a year.

Statement of cash flows presents a summary of an entity’s sources (inflows) and uses
(outflows) of cash for a period of time, such as a month or a year.

The financial statements of the Company (which is taken from the accounting equation
are presented as follows:

The Company
Statement of Comprehensive Income
For the month ended January 31, 2014

Income
Service Revenues 45,000.00
Total income
Less Expenses
Salaries Expense 12,000.00
Rent Expense 10,000.00
Utilities Expense 1,000.00
ACT1101 FAR EASTERN UNIVERSITY PROF. BERNADETTE RAMOS

Total expenses 23,000.00

Profit 22,000.00
Other Comprehensive Income -
Total Comprehensive Income 22,000.00

The Company
Statement of Changes in Equity
For the month ended January 31, 2014

Owner's, Capital Jan.1,2014 -

Changes in equity
Investment 1,000,000.00
Profit 22,000.00
Drawing (100,000.00)
Total increase in capital 922,000.00
Owner's, Capital Jan.1,2014 922,000.00

The Company
Statement of Financial Position
As of January 31, 2014

Assets
Current
Cash 521,500.00
Supplies 500.00
Total current assets 522,000.00
Non-current
Land 400,000.00
Total noncurrent assets 400,000.00
Total assets 922,000.00

Liabilities & Owner's Equity

Liabilities -
Owner's, Capital Jan.1,2014 922,000.00
Total Liabilities & Owner's Equity 922,000.00

The Company
Statement of Cash Flows
For the month ended January 31, 2014

Inflows(outflows) of cash - operating activities

ACT1101 FAR EASTERN UNIVERSITY PROF. BERNADETTE RAMOS

Collection from cash customers 15,000.00

Payment of rent (10,000.00)
Payment of salaries (12,000.00)
Payment of utilities (1,000.00)
Payment of AP (500.00)
Collection of AR 30,000.00
Net inflow-operating activities 21,500.00

Inflows(outflows) of cash - investing activities

Payment for land (400,000.00)
Net outflow-investing activities (400,000.00)

Inflows(outflows) of cash - financing activities

Investment of the owner 1,000,000.00
Withdrawal of the owner (100,000.00)
Net outflow-financing activities 900,000.00

Increase in Cash 521,500.00

Cash Jan.1,2014 0
Cash Dec.31, 2014 521,500.00