CHAPTER 2

ACCOUNTING EQUATION

PRINCIPLE OF ACCOUNTING 1
 CHAPTER 2: Accounting Equation
OBJECTIVE:

ü After studying this chapter, you should be able to

Ø Define accounting equations and the basic elements of

accounting equations
Ø Transaction analysis in accounting equation

PRINCIPLE OF ACCOUNTING 2
CHAPTER 2: ACCOUNTING EQUATION

2.1. The basic elements of Accounting Equation

2.2. The use of Accounting Equation

PRINCIPLE OF ACCOUNTING 3
2.1. The basic elements of Accounting
Equation
2.1.1. Assets
2.1.2. Liabilities
2.1.3. Equity

PRINCIPLE OF ACCOUNTING 4
2.1. The basic elements of Accounting Equation
2.1.1. Assets

Assets is a resource controlled by the entity

as a result of past events and from which
future economic benefits are expected to
flow to the entity.

PRINCIPLE OF ACCOUNTING 5
2.1. The basic elements of Accounting Equation
2.1.1. Assets
CURRENT ASSETS

An asset should be classified as a current asset when it is:

Expected to be realised in, or is held for sale or
consumption in, the entity's normal operating
cycle
Held primarily for the purpose of being traded
Expected to be realised within 12 months after the
reporting date
Cash or a cash equivalent which is not restricted in its
use
All other assets should be classified as non-current assets
PRINCIPLE OF ACCOUNTING 6
2.1. The basic elements of Accounting Equation
2.1.1. Assets
CURRENT ASSETS

An asset should be classified as a current asset when it is:

Expected to be realised in, or is held for sale or
consumption in, the entity's normal operating
cycle
Held primarily for the purpose of being traded
Expected to be realised within 12 months after the
reporting date
Cash or a cash equivalent which is not restricted in its
use
All other assets should be classified as non-current assets
PRINCIPLE OF ACCOUNTING 7
2.1. The basic elements of Accounting Equation
2.1.1. Assets
CURRENT ASSETS

An asset should be classified as a current asset when it is:

Expected to be realised in, or is held for sale or
consumption in, the entity's normal operating
cycle
Held primarily for the purpose of being traded
Expected to be realised within 12 months after the
reporting date
Cash or a cash equivalent which is not restricted in its
use
All other assets should be classified as non-current assets
PRINCIPLE OF ACCOUNTING 8
• EX: 01/01/2018: credit sale 2,000$, credit
term: after 36 months: non current assets
• 31/12/2018: credit sale 2,000$: credit term
24 months => non current assets
• 31/12/2019: credit sale 2,000$: credit term
12 months => current assets

PRINCIPLE OF ACCOUNTING 9
2.1. The basic elements of Accounting Equation
2.1.1. Assets

NON- CURRENT ASSETS

Non-current includes tangible, intangible operating and financial
assets of a long-term nature. Other terms with the same meaning
can be used (eg 'fixed', 'long-term').
NOTE:
The term 'operating cycle' is defined by the standard as follows.
The operating cycle of an entity is the time between the acquisition
of assets for processing and their realisation in cash or cash
equivalents PRINCIPLE OF ACCOUNTING 10
2.1. The basic elements of Accounting Equation
2.1.1. Assets

Examples of assets:
• Land & buildings
• Motor Vehicles
• Plant & Machinery
• Fixtures & fitting
• Cash
• Inventory
• Receivables (debtors)
PRINCIPLE OF ACCOUNTING 11
2.1. The basic elements of Accounting Equation
2.1.2. Liabilities

Liabilities is a present obligation of the entity

arising from past events, the settlement of
which is expected to result in an outflow from
the entity of resources embodying economic
benefits.

PRINCIPLE OF ACCOUNTING 12
2.1. The basic elements of Accounting Equation
2.1.2. Liabilities
CURRENT LIABILITIES

A liability should be classified as a current liability

when it is:
Expected to be settled in the entity's normal
operating cycle
Due to be settled within 12 months of the
reporting date

PRINCIPLE OF ACCOUNTING 13
2.1. The basic elements of Accounting Equation
2.1.2. Liabilities
CURRENT LIABILITIES

A liability should be classified as a current liability

when it is:
Expected to be settled in the entity's normal
operating cycle
Due to be settled within 12 months of the
reporting date
Held primarily for the purpose of being traded
All other liabilities should be classified as non-
current liabilities PRINCIPLE OF ACCOUNTING 14
2.1. The basic elements of Accounting Equation
2.1.2. Liabilities

Examples of Liabilities:
• Bank loan or overdraft

PRINCIPLE OF ACCOUNTING 15
2.1. The basic elements of Accounting Equation
2.1.2. Liabilities

Examples of Liabilities:
• Bank loan or overdraft

PRINCIPLE OF ACCOUNTING 16
2.1. The basic elements of Accounting Equation
2.1.2. Liabilities

Examples of Liabilities:
• Bank loan or overdraft
• Payables (creditors)

PRINCIPLE OF ACCOUNTING 17
2.1. The basic elements of Accounting Equation
2.1.2. Liabilities

Examples of Liabilities:
• Bank loan or overdraft
• Payables (creditors)
• Taxation

PRINCIPLE OF ACCOUNTING 18
2.1. The basic elements of Accounting Equation
2.1.3. Equity

Equity is the residual interest in the assets of the entity

after deducting all its liabilities.
Equity is also the amount invested in a business by the
owners.

PRINCIPLE OF ACCOUNTING 19
2.1. The basic elements of Accounting Equation
2.1.3. Equity

EQUITY
Capital reserves usually have to be set up by law, whereas
revenue reserves are appropriations of profit.
With a sole trader, profit was added to capital. However,
in a limited company, share capital and profit have to be
disclosed separately, because profit is distributable as a dividend
but share capital cannot be distributed. Therefore any retained
profits are kept in the retained earnings reserve
PRINCIPLE OF ACCOUNTING 20
2.2. The use of Accounting Equation
2.2.1. The basic accounting equation
2.2.2 Transaction analysis in
accounting equation

PRINCIPLE OF ACCOUNTING 21
2.2. The use of Accounting Equation
2.2.1. The basic accounting equation

DEFINITION of Accounting Equation

The accounting equation is considered to be the

foundation of the double-entry accounting system.

The accounting equation shows on a company's balance

sheet whereby the total of all the company's assets
equals the sum of the company's liabilities and
shareholders' equity.

PRINCIPLE OF ACCOUNTING 22
2.2. The use of Accounting Equation
2.2.1. The basic accounting equation

PRINCIPLE OF ACCOUNTING 23
2.2. The use of Accounting Equation
2.2.1. The basic accounting equation

PRINCIPLE OF ACCOUNTING 24
2.2. The use of Accounting Equation
2.2.1. The basic accounting equation

PRINCIPLE OF ACCOUNTING 25
2.2. The use of Accounting Equation
2.2.1. The basic accounting equation

PRINCIPLE OF ACCOUNTING 26
2.2. The use of Accounting Equation
2.2.1. The basic accounting equation

PRINCIPLE OF ACCOUNTING 27
2.2. The use of Accounting Equation
2.2.1. The basic accounting equation

PRINCIPLE OF ACCOUNTING 28
2.2. The use of Accounting Equation
2.2.1. The basic accounting equation
Accounting equation

TOTAL
EQUITY LIABILITIES
ASSETS

Equity/ Capital = Capital introduced + Retained profits

Equity/ Capital = Capital introduced + (Earned profit – Drawings)

Profit/Loss = Revenue Drawings are amounts

- Expenditure of money taken out of a
business by its owners
PRINCIPLE OF ACCOUNTING 29
2.2. The use of Accounting Equation
2.2.1. The basic accounting equation
Accounting equation

TOTAL
EQUITY LIABILITIES
ASSETS

Equity/ Capital = Capital introduced + Retained profits

Equity/ Capital = Capital introduced + (Earned profit – Drawings)

Profit/Loss = Revenue Drawings are amounts

- Expenditure of money taken out of a
business by its owners
PRINCIPLE OF ACCOUNTING 30
2.2. The use of Accounting Equation
2.2.1. The basic accounting equation
Accounting equation

TOTAL
EQUITY LIABILITIES
ASSETS

Equity/ Capital = Capital introduced + Retained profits

Equity/ Capital = Capital introduced + (Earned profit – Drawings)

Profit/Loss = Revenue Drawings are amounts of

- Expenditure money taken out of a
business by its owners
PRINCIPLE OF ACCOUNTING 31
2.2. The use of Accounting Equation
2.2.1. The basic accounting equation
Accounting equation

PRINCIPLE OF ACCOUNTING 32
2.2. The use of Accounting Equation
2.2.1. The basic accounting equation

How to Calculate the Accounting Equation:

ü The balance sheet holds the basis of the accounting
equation.
ü Locate the company's total assets on the balance
sheet for the period.
ü Total all liabilities, which should be a separate
listing on the balance sheet.
ü Locate total shareholder's equity and add the
number to total liabilities.
ü Total assets will equal the sum of liabilities and
total equity. PRINCIPLE OF ACCOUNTING 33
2.2. The use of Accounting Equation
2.2.1. The basic accounting equation

ü The basic accounting equation is considered to be the

foundation of the double-entry accounting system. The
accounting equation shows on a company's balance
sheet whereby the total of all the company's assets equals the
sum of the company's liabilities and shareholders' equity.

ü While assets represent the valuable resources owned by the

company, the liabilities represent its obligations. Both
liabilities and shareholders' equity represent how the assets of a
company are financed. If it's financed through debt, it'll show
as a liability, and if it's financed through issuing equity shares
to investors, it'll show in shareholders' equity.
PRINCIPLE OF ACCOUNTING 34
2.2. The use of Accounting Equation
2.2.2 Transaction analysis in accounting equation

The accounting equation MUST remain in

balance after each transaction.

PRINCIPLE OF ACCOUNTING 35
2.2. The use of Accounting Equation
2.2.2 Transaction analysis in accounting equation

The accounting equation MUST remain in

balance after each transaction.

PRINCIPLE OF ACCOUNTING 36
2.2. The use of Accounting Equation
2.2.2 Transaction analysis in accounting equation

PRINCIPLE OF ACCOUNTING 37
2.2. The use of Accounting Equation
2.2.2 Transaction analysis in accounting equation

ASSET = LIABILITIES + EQUITY

1 Increase Increase

2 Reduce Reduce

3 Increase and reduce No change

4 No change Increase and reduce

PRINCIPLE OF ACCOUNTING 38
2.2. The use of Accounting Equation
2.2.2 Transaction analysis in accounting equation

ASSET = LIABILITIES + EQUITY

1 Increase Increase

PRINCIPLE OF ACCOUNTING 39
2.2. The use of Accounting Equation
2.2.2 Transaction analysis in accounting equation

ASSET = LIABILITIES + EQUITY

1 Increase Increase

TRANSACTION (1). INVESTMENT BY OWNER

On September 1, 202X, he invests $15,000 cash
in the business.

PRINCIPLE OF ACCOUNTING 40
2.2. The use of Accounting Equation
2.2.2 Transaction analysis in accounting equation

ASSET = LIABILITIES + EQUITY

2 Increase AND No change

decrease

TRANSACTION (2). PURCHASE OF

EQUIPMENT FOR CASH
Softbyte purchases computer equipment for
$7,000 cash.
PRINCIPLE OF ACCOUNTING 41
2.2. The use of Accounting Equation
2.2.2 Transaction analysis in accounting equation

ASSET = LIABILITIES + EQUITY

3 Increase Increase

TRANSACTION (3). PURCHASE OF SUPPLIES

ON CREDIT Softbyte purchases for $1,600 from
Mobile Solutions headsets and other computer
accessories expected to last several months.
asset = liabilities + equity
cash + supplies + equipment = 1600 +15000
15000 + 1600 + 7000

= 16 600
16 600 PRINCIPLE OF ACCOUNTING 42
2.2. The use of Accounting Equation
2.2.2 Transaction analysis in accounting equation

ASSET = LIABILITIES + EQUITY

4 Increase Increase

TRANSACTION (4). SERVICES PERFORMED

FOR CASH: Softbyte receives $1,200 by cash from
services.

PRINCIPLE OF ACCOUNTING 43
2.2. The use of Accounting Equation
2.2.2 Transaction analysis in accounting equation

ASSET = LIABILITIES + EQUITY

5 Increase Decrease

TRANSACTION (5). PURCHASE OF

ADVERTISING ON CREDIT Softbyte receives a bill
for $250 from the Daily News for advertising on its
online website but postpones payment until a later
date.
PRINCIPLE OF ACCOUNTING 44
2.2. The use of Accounting Equation
2.2.2 Transaction analysis in accounting equation

ASSET = LIABILITIES + EQUITY

6 Increase Increase

TRANSACTION (6). Servieces performed for cash

and credit: Softbyte perform $3,500 of app
development services for customers. The company
receives cash of $1,500 from customers, and $2,000
on credit.

PRINCIPLE OF ACCOUNTING 45
2.2. The use of Accounting Equation
2.2.2 Transaction analysis in accounting equation

ASSET = LIABILITIES + EQUITY

7 Decrease Decrease

TRANSACTION (7). PAYMENT OF EXPENSES

Softbyte pays the following expenses in cash for
September: of ce rent $600, salaries and wages of
employees $900, and utilities $200.

PRINCIPLE OF ACCOUNTING 46
2.2. The use of Accounting Equation
2.2.2 Transaction analysis in accounting equation

ASSET = LIABILITIES + EQUITY

8 Decrease Decrease

TRANSACTION (8). PAYMENT OF ACCOUNTS

PAYABLE Softbyte pays its $250 Daily News bill in
cash.

PRINCIPLE OF ACCOUNTING 47
2.2. The use of Accounting Equation
2.2.2 Transaction analysis in accounting equation

ASSET = LIABILITIES + EQUITY

9 Increase and
Decrease

TRANSACTION (9). RECEIPT OF CASH ON

ACCOUNT Softbyte receives $600 in cash from
customers who had been billed for services [in
Transaction (6)].

PRINCIPLE OF ACCOUNTING 48
2.2. The use of Accounting Equation
2.2.2 Transaction analysis in accounting equation

ASSET = LIABILITIES + EQUITY

10 Decrease Decrease (drawings)

TRANSACTION (10). WITHDRAWAL OF CASH BY

OWNER: Ray Neal withdraws $1,300 in cash from the
business for his personal use.

PRINCIPLE OF ACCOUNTING 49
 PRACTICE 1
Transaction made by Victoty Co., for the month of
August are shown below. Prepare a tabular analysis
which shows the effects of these transactions on the
expanded accounting equation.
(1) The owner invested $25,000 cash in the business.
(2) The company purchased $7,000 of office equipment
on credit.
(3) The company received $8,000 cash in exchange for
services performed.
(4) The company paid $850 for this month’s rent.
(5) The owner withdraw $1,000 cash for personal use.

PRINCIPLE OF ACCOUNTING 50
 PRACTICE 2
1. Let's assume that J. Ott forms a sole proprietorship
called Accounting Software Co. (ASC). On
December 1, 2018, J. Ott invests personal funds of
$10,000 to start ASC.
2. On December 2, 2018 J. Ott withdraws $100 of cash
from the business for his personal use.
3. On December 3, 2018 Accounting Software Co.
spends $5,000 of cash to purchase c om put e r
equipment for use in the business.
4. On December 4, 2018 ASC obtains $7,000 by
borrowing money from its bank.
5. On December 5, 2018 Accounting Software Co. pays
$600 for ads that were run in recent days.
PRINCIPLE OF ACCOUNTING 51