Chapter 3 – The Accounting Equation and the Double Entry System

ELEMENTS OF THE FINANCIAL STATEMENTS

Financial Position

Assets are economic resources or things of value and rights owned by the business. This is the most
basic and simplest definition of an asset, as per framework, an ASSET is a resource controlled by the
enterprise as a result of past events and from which future economic benefits are expected to flow to the
enterprise. Taking this definition element by element, we have these discussions:
 Assets are resources controlled by the enterprise – the company is the entity that has title, control
and authority over the use, access and even disposal of the said resource.
 The acquisition of the assets is a result of past events – the event should have already occurred that
led to the acquisition of the asset.
 Future economic benefits are expected to flow into the enterprise as a result of the use of the asset –
the use of such resources would lead to the potential receipt of other assets like cash, receivable or
inventory.

An asset may be viewed in terms of:

o Money
o Claims to money (receivables)
o Products (inventory – raw materials, work-in-process & finished goods)
o Productive Resources (machineries & equipment)
o Ownership interest on other enterprises (investments)

Liabilities are debts of the enterprise to outside parties like banks, creditors, suppliers and some
government agencies. Per framework, LIABILITY is a present obligation of the enterprise arising from past
events, the settlement of which is expected to result in an outflow from the enterprise of resources embodying
economic benefits.
 Liabilities are obligations of the enterprise requiring or giving responsibility to the enterprise to
commit an asset for the fulfillment of such obligation.
 These liabilities were incurred as a result of past events
 Future transfer of economic benefits are expected to flow out of the enterprise as a result of the
satisfying the fulfillment or simply the settlement of such obligations.
 Harmonizing Nature of Assets & Liabilities – in every transaction recorded, the balance of the
accounting equation should always be maintained.

An obligation may be settled through:

o Payment of cash
o Transfer of other assets
o Provision of services
o Replace of that obligation with another obligation
o Conversion of that obligation to equity.

Equity is the residual interest of the owners after deducting the total liabilities from the total assets. It
is increased by additional investment from the owners and an income generated by the enterprise and is
deducted by a pull-out of investment by the owners of the incurrence of a loss in its operations.

Results of Operations

Income increases economic benefits in the form of increases of assets or decreases in liabilities that
result in increases in equity, other than those coming from contributions from the owners. An income may
either be revenue or a gain for the enterprise. Revenue is an income arising from the ordinary course of
business of the enterprise; it may be considered as sales, fees, interest, dividends, rent, royalties, etc. A gain
on the other hand represents those other items that do not meet the definition of revenue but would still be
leading to the increase of economic benefits.
Expenses decrease economic benefits in the form of decreases in assets or increases in liabilities
which would eventually decrease equity. Expenses may be classified as Cost of Goods Sold, Operating
Expenses (Selling & Administrative) and Losses.

Chapter 3 – The Accounting Equation & The Double Entry System 3-1
THE ACCOUNT

An account is a detailed record of the increases, decreases and balance of each element that appears on
each element of the financial statements, i.e. assets, liabilities and equity for the balance sheet and income and
expenses for the income statement. The account is most basic summary device in accounting. The simplest
form of the account is what we call the “T-Account.” Its name speaks for itself because of its resemblance to
the letter T.

Account Title
Left side or Right Side or
Debit Side Credit Side
(Dr.) (Cr.)

THE ACCOUNTING EQUATION

ASSETS = LIABILITIES + EQUITY

This accounting equation basically reflects the company controlled financial resources (assets) and
financial obligations (liabilities & equity). It must be emphasized that this accounting equation is the most
basic guide whenever we record transactions using the double-entry system:
 Whenever we record transactions, the equality of such equation should ALWAYS be
maintained.
 That a debit entry ALWAYS has a corresponding credit entry.
 The amount of total debit is ALWAYS equal to the amount of total credit.

Through this accounting equation, we are also reminded of the “normal balance” of each element of
the financial statements. Normal Balance is the side (debit or credit) where an account is usually increased.
The normal balance of these accounts follows their side on the accounting equation. So looking at the
accounting equation, the assets are on the left side of the equation that is why the normal balance of assets is
the left side (debit) while liabilities and equity are on the right side of the equation that is why the normal
balance of these elements are on the right side or what we call the credit side.
Debit Credit

ASSET = LIABILITIES + EQUITY

Knowledge of the normal balance of every account is very important because knowing the
normal balance will help the preparer on when to debit or credit an account for every transaction that
he/she has to record. The concept is simple: since the normal balance of an asset is debit, it therefore follows
that every increases in asset is a debit entry and a decrease in asset is a credit entry. On the other hand, since
liabilities and equity has a credit normal balance, every increase in liability or equity is a credit entry while a
decrease in such accounts is a debit entry.

BALANCE SHEET ACCOUNTS

ASSETS LIABILITIES & EQUITY

Debit Credit Debit Credit
(+) (-) (-) (+)
Increases Decreases Decreases Increases

Chapter 3 – The Accounting Equation & The Double Entry System 3-2
 As for the Income Statement accounts; namely the income and expense accounts, the rules on debit
credit follow the relationship such accounts to the Equity account.
 Expenses decrease the Equity account, to decrease equity, we debit equity and so the normal
balance of an expense is debit.
 Income increase the Equity account, to increase equity, we credit equity and so the normal
balance of income is credit

INCOME STATEMENT ACCOUNTS

Debit due to Decrease in Equity Credit due to Increase in Equity
EXPENSES INCOME
Debit Credit Debit Credit
(+) (-) (-) (+)
Increases Decreases Decreases Increases

The summary of the previous discussion is provided below:

Normal
Decrease
Account Balance Increases s
Assets Debit Debit Credit
Liabilities Credit Credit Debit
Equity Credit Credit Debit
Income Credit Credit Debit
Expenses Debit Debit Credit

TYPES & EFFECTS OF TRANSACTIONS

Though different entities are involved in different types of transactions, these transactions may be
summarized in four different types:
1. Source of Assets (SA) – in this transaction, an asset account and a corresponding claim
(liabilities or equity) are increased. Examples: Loaning from a bank and Sale of Goods.
2. Exchange of Assets (EA) – in this transaction, an asset account is increased while another asset
account is decreased. Examples: Collection of Receivables and cash purchase of an
equipment.
3. Use of Asset (UA) – both an asset and claims account are decreased. Examples: payment of the
bank loan or payment of salaries.
4. Exchange of Claims (EC) – in this transaction, a claim account is increased with a corresponding
decrease in another claim account. Examples: mere receipt of the electric bill without the
payment yet and transfer of accounts payable to notes payable.
For every type of transaction, the equality of the accounting equation is always maintained. These
types of transactions may be further classified as to the types of effects of transactions:

Types of Transactions Effects of Transactions

Source of Assets (SA) 1. Increase in Asset = Increase in Liabilities
2. Increase in Assets = Increase in Owners’ Equity
Exchange of Asset (EA) 3. Increase in one Asset = Decrease in another Asset
Use of Asset (UA) 4. Decrease in Asset = Decrease in Liabilities
5. Decrease in Assets = Decrease in Owners’ Equity
Exchange of Claims (EC) 6. Increase in Liabilities = Decrease in Owners’ Equity
7. Increase in Owners’ Equity = Decrease in Liability
8. Increase in one Liability = Decrease in another Liability
9. Increase in Owners’ Eq. = Decrease in another Owners’ Eq.

Chapter 3 – The Accounting Equation & The Double Entry System 3-3
Financial Transaction Worksheet
Jose Anton decided to establish a sole proprietorship business and named it JOAN Web designs. The
business is into designing web sites. During December 201X, the first month of operations, various financial
transactions took place.

Dec.1 Jose Anton started his new business by depositing P250, 000 in a bank account in the
name of JOAN Web designs at PS Bank.
5 He brought his computer equipment which now has a fair market value of P50, 000
which he usually used personally; now to be used in his business.
7 Bought additional computer equipment for cash amounting to P75, 000.
8 Computer Supplies in the amount of P9, 000 were purchased on account.
9 Collected P75, 000 in cash for designing the basic interactive website of a multi-national
company.
10 Performed web design services for P27, 750 on account to an exporter based in Manila.
11 JOAN Web designs paid P15, 000 to Bills Unlimited, a one-stop bills payment service
company that takes care of paying all of the bills of other companies like water,
electricity, telephones, etc.
12 Purchased additional computer equipment for P55, 500 on credit; paid P5, 500 cash and
the balance payable in 60 days.
15 Paid his web designers P45, 000 for their salaries for half month
22 Collected P6, 000 on accounts receivable.
24 Issued a check for P4, 000 in partial payment of the amount owed for the computer
supplies.
26 Jose Anton withdrew P10, 000 in cash for personal use.

Required: Prepare a Financial Transaction Worksheet for JOAN Web Designs for the month of December.
Prepare the T-Accounts of JOAN Web Designs.

Elements of the Financial Statements

Balance Sheet Income Statement
Profits/
Assets Liabilities Equity Revenues Expenses (Loss)
a. 760,000 360,000 ? a. 840,000 ? 360,000
b. 860,000 ? 592,000 b. 2,400,000 ? 540,000
c. ? 108,000 760,000 c. 1,300,000 860,000 ?
2,000,00
d. 626,600 376,240 ? d. ? 0 720,000
(100,000 1,800,00
e. ? 800,000 ) e. ? 0 (400,000)

Additional Exercises:
Use the formulas learned in the discussion of the elements of the financial statements, answer the questions
below:
1. At the beginning of the year, the assets of the company were P360, 000 and its owners’ equity was
P200, 000. During the year, assets increased by P120, 000 and liabilities increased by P20, 000.
What was the owner’s equity at the end of the year?
2. At the start of the year, Faith Merchandising had liabilities of P100, 000 and owner’s equity of P96,
000. If assets increased by P40, 000 and liabilities decreased by P30, 000. What was the owner’s
equity at the end of the year?
3. An Environment Consultant Firm earned P362, 000 but incurred a loss of P96, 000. How much was
spent for the expenses of the firm?
4. A company has operating expenses of P153, 000 and loss of P27, 500. How much was its total
revenues?

Chapter 3 – The Accounting Equation & The Double Entry System 3-4
 5. Classifying and Recording Transactions
For the given transactions below, indicate whether it is a Source of Asset (SA), Use of Asset
(UA), Exchange of Asset (EA) or Exchange of Claims (EC). On the succeeding columns, indicate the
effects of the transactions to the Assets, Liabilities and Equity by putting (+) if it will increase or (-) if it
will decrease. If the transaction doesn’t need to be recorded, simply write “N/E” for every column.

A L Eq ToT Debit Credit

Transactions
1.The owner, Mr. Sicat received P1.5M from his employer when
“No Entry”
he retired from his job.
2.Mr. Sicat invested half of his retirement pay into his own
+ + SA Cash Sicat, Capital
business named Sicat Cleaning Services.
3. Mr. Sicat also invested his building to be used for his
+ + SA Building Sicat, Capital
business amounting to P500,000
4. Acquired Computer Equipment worth P50, 000 on account. Computer Accounts
+ + SA
Equipment Payable
5. Purchased Furniture and Fixtures amounting to P25,000 on Furniture & Accounts
+ + SA
credit Fixtures Payable
6. Loaned a Delivery Vehicle from PS Bank worth P500, 000 Service
+ + SA Loans Payable
payable every end of the year. Vehicle
7. Issued a promissory note for the purchase of office supplies Office
+ + SA Notes Payable
worth P7, 500. Supplies
8.Bought a desktop computer for P40, 000; paid 50% down EA, Computer Cash, Notes
+,- +
and issued a promissory note for the balance due in 60 days. SA Equipment Payable
9. Acquired a personal copier for P39, 500 on credit; paid Cash,
EA, Office
P9,500 cash, balance is due in 30 days. +,- + Accounts
SA Equipment
Payable
10.Bought office furniture for P50, 000 in cash. Furniture &
+,- EA Cash
Fixtures
11.Interviewed and hired the office staff that he needs in running
“No Entry”
his business
12.Rendered services and received P12, 000 cash. Cleaning
+ + SA Cash
Revenues
13.Performed services and received a note from his client Notes Cleaning
+ + SA
amounting to P15, 000. Receivable Revenues
14.Performed services for P27, 750 on credit. Accounts Cleaning
+ + SA
Receivable Revenues
15.Services worth P10, 000 was earned on account by cleaning Accounts Cleaning
+ + SA
OYG Bldg. in the CSF. Receivable Revenues
16.Received P7, 000 from the client who issued the promissory Notes
+,- EA Cash
note. Receivable
17.Bought additional office chairs for P8, 000 on credit Furniture & Accounts
+ + SA
Fixtures Payable
18.Issued a check for P32, 500 to pay for salaries. Salaries
- - UA Cash
Expense
19.Performed services for P10, 250 cash Cleaning
+ + SA Cash
Revenues
20.Performed services for P11, 500 on credit. Accounts Cleaning
+ + SA
Receivable Revenues
21.Collected P6, 000 on accounts receivable. Accounts
+,- EA Cash
Receivable
22.Issued a check for P4, 000 in partial payment of the amount Accounts
- - UA Cash
owed for office computer equipment. Payable
23.Received the Electric bill amounting to P2, 250 to be paid Utilities Utilities
+ - EC
next month. Expense Payable
24.Billed by TFX Advertising Company for the advertisement Advertising Accounts
+ - EC
of Sicat Cleaning Services, P5,000 Expense Payable
25.Paid P2, 500 for the repair of his personal car usually used by
“No Entry”
his son.
26.Mr Sicat withdrew P50, 000 in cash from the business for Sicat,
- - UA Cash
personal use. Drawings
27.Collected P10, 000 from his previously billed clients. Accounts
+,- EA Cash
Receivable
Name: __________________________ Section: ____________

Chapter 3 – The Accounting Equation & The Double Entry System 3-5
The Trial Balance of SinilaM Cleaners for the month ending November 30, 201X is shown below:

SinilaM Cleaners
Trial Balance
Nov. 30, 201X

Acct. No. Account Titles Debit Credit

110 Cash 175,500

120 Accounts Receivable 85,000
130 Office Supplies 12,462
140 Cleaning Supplies 31,050
150 Cleaning Equipment 52,425
160 Office Equipment 35,745
170 Office Furniture and Fixtures 17,540
180 Service Vehicle 275,000
210 Notes Payable 50,000
220 Accounts Payable 25,000
230 Loans Payable 275,000
310 Morales, Capital 334,722
320 Morales, Withdrawals -
410 Cleaning Revenues -
510 Salaries Expense -
520 Gasoline Expense -
530 Uniform Expense -
540 Rent Expense -
560 Utilities Expense -
570 Miscellaneous Expense -
TOTALS 684,722 684,722

The following transactions took place for the month of December, 201X.

Dec.4 Received P5, 000 from previously billed clients.

6 Paid P7, 500 for one month’s rent.
7 Bought additional office furniture and fixtures for P16, 500 in cash.
8 Performed services for P10, 500 in cash.
9 Performed services for P27, 750 on account.
11 Bought cleaning equipment for P40, 000; paid 50% down, balance in 30 days.
12 Purchased office equipment for P55, 500 on credit; paid P5, 500 cash and issued a note
for the balance.
13 Purchased additional office supplies for cash worth P1, 250.
14 Spent P25, 000 for the uniform of the employees of the company.
15 Bought additional office chairs for P8, 000 on credit.
16 Issued a check for P32, 500 to pay for salaries.
20 Performed services for P10, 250 on credit.
21 Paid P7, 250 for the bill from PLDT.
22 Collected P6, 000 on accounts receivable.
24 Issued a check for P4, 000 in partial payment of the amount owed for office chairs.
26 Paid P5, 750 the for the gasoline receipts issued by Caltex for the gasoline consumed by
the service vehicle for the month.
27 Paid P2, 500 for the monthly electric bill.
28 Morales withdrew P10, 000 in cash for personal use.
29 Spent P7, 850 for the regular change oil and tune up of the service vehicle.

Chapter 3 – The Accounting Equation & The Double Entry System 3-6
Name: __________________________ Section: ____________

The Trial Balance Conrado Diego Management consultant for the month ending September 30, 201X is
shown below:

Conrado Diego Management Consultant

Trial Balance
Sept. 30, 201X

Acct. No. Account Titles Debit Credit

110 Cash 85,742

120 Accounts Receivable 12,500
130 Office Supplies 5,624
140 Office Equipment 32,500
170 Office Furniture and Fixtures 25,250
180 Service Vehicle 350,000
210 Notes Payable 50,000
220 Accounts Payable 25,000
230 Loans Payable 350,000
310 Diego, Capital 86,616
320 Diego, Withdrawals -
410 Consulting Revenues -
510 Salaries Expense -
520 Advertising Expense -
530 Rent Expense -
540 Utilities Expense -
550 Miscellaneous Expense -
TOTALS 511,616 511,616

The following transactions took place for the month of October, 201X.

Oct. 1 Deposited P62, 000 cash in a bank account in the name of the new company.
3 Acquired office supplies on account, P5, 750.
5 Acquired Office equipment by issuing a promissory note, P15, 600.
6 Acquired office furniture and fixtures costing P50, 000, paying P10, 000 cash as down
payment and financing the remaining P40, 000 by issuing a note payable.
9 Received P11, 800 cash for consulting services rendered.
10 Paid for a newspaper advertisement, P15, 700.
12 Paid for the repairs and maintenance of the service vehicle amounting to P5,000.
13 Paid P5, 000 to the computer technician who repaired the computer equipment.
14 Paid rent of the office, P7, 500.
15 Billed customers P18, 600 for consulting services rendered.
16 Paid salaries P8, 400.
20 Received P9, 800 from customers billed on October 15.
22 Paid amount due on note payable, P10, 000.
25 Paid telephone expense, P900.
25 Paid salaries P7, 900.
26 Billed customers for consulting services rendered, P22, 500.
28 Withdrew P10, 000 from the business.

Chapter 3 – The Accounting Equation & The Double Entry System 3-7