Lesson 5.

The Accounting
Equation

Fundamentals of Accountancy, Business,

and Management 1
Accountancy, Business, and Management

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Suppose that you are an
investor. Would you invest
your money in a business
that has incurred debt and
has an enormous obligation
to settle?

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Debt and obligations
are not necessarily an
indication of bad
financial management.

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To know whether
the debt is good or
excessive, you
should compare
this liability with
the company's
assets and equity.

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Accounting has an
established system
to provide
information on this.

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Quick Look

The Happy Barbers

James Dela Cruz decided to establish a barbershop business near the city
called The Happy Barbers. He is the sole proprietor of the said business.
He intended to use his savings but later found out that it was not enough
to finance everything needed to operate the business.

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Quick Look

The Happy Barbers

Using a credit card, he purchased four wall-mounted mirrors, six barber
chairs, and three benches. He bought the essential haircut equipment,
hair products, and other consumables with cash. He also deposited an
amount of ₱200,000 in The Happy Barbers's bank account to serve as its
initial operating funds. Afterward, he started the business operation. It
ran smoothly and gained income as many customers availed of his
services.

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Quick Look

Questions to Ponder

1. What are things of value owned by The Happy Barbers?

2. How did James Dela Cruz acquire those things for his barbershop?
3. Assuming that the credit card obligation has not been settled, do you
think James has the full claim over all assets owned by The Happy
Barbers?

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Learning Competency

Illustrate the accounting equation (ABM_FABM11-IIIb-c-17).

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Learning Objectives

At the end of this lesson, you should be able to do the following:

● Describe the elements and principles of the accounting
equation.
● Demonstrate the normal balance of transactions and how
these affect the accounting equation.
● Explain the importance of accounting information to
businesses.

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What is the significance of the
accounting equation in accounting?

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The Accounting Equation

● Business transactions: activities that change the assets,

liabilities, and equity of a company
○ Which of these accounts are affected by every activity,
and how?

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 The Basic Accounting Equation

● expresses the relationship between the assets, liabilities,

and equity
● states that assets should equal the sum of liabilities and
equity

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 The Basic Accounting Equation

Assets = Liabilities + Owner’s Equity

● implies that any transaction that changes the left

side would change the right side
● fundamental principle in the balance sheet and
double-entry bookkeeping

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 The Basic Accounting Equation

Balance Sheet Double-Entry System

reports in detail the every transaction is recorded

business’s assets, liabilities, in at least two accounts that
and equity are affected in opposite ways

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Elements of the Accounting Equation

Liabilities
obligations
needed to be
Assets settled by a
the resources business entity
owned by the
business
Equity
details of
ownership

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 The Basic Accounting Equation

Assets
● resources with financial
value owned by an entity
● used to generate revenue
● when bought in cash, the
rights on the asset are
transferred to the
business

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 The Basic Accounting Equation

Tangible Assets Financial and

Intangible Assets
● cash
● office supplies
● machineries ● stocks and bonds
● buildings ● copyrights and patents
● land
● equipment

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 The Basic Accounting Equation

Liabilities
● financial obligations that
arise from previous
business transactions
○ debt or costs
○ normally incurred for
growth, expansion, and
liquidity

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 The Basic Accounting Equation

Short-term liabilities Long-term liabilities

● due within 12 months ● due beyond 12 months

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 The Basic Accounting Equation

Liabilities
● decrease company
assets once settled
● but rights are
transferred fully to
the owners

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 The Basic Accounting Equation

Owner’s Equity
● the percentage of the
business that belongs to
the owner or
shareholders
● value of investments if all
obligations were settled

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 The Basic Accounting Equation

Owner’s Equity
● the total amount of
money to be left once
the enterprise
liquidates its assets
and settles all its
liabilities

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 The Basic Accounting Equation

● details the transactions

that affect the owner's
equity:
Expanded Accounting ○ capital
Equation ○ revenue
○ expenses
○ drawings

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Revenue Expenses

● income or earnings ● expenditures incurred in

derived from the the course of business
delivery of goods and operations
services ● Examples:
● Examples: ○ expenses on salaries,
○ sales, professional office supplies,
fees, service utilities and the
revenue, etc. internet
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Capital Drawings

● investments made by the ● the money or assets

investor or business withdrawn from the
owners to the business business account for
personal use (sole
proprietorship)
● in corporation, it is
dividends

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Expanded Accounting Equation

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 Back to Operation

Closer
Look

Mary Salon is one of the biggest salon chains in the Philippines.

They offer haircuts, hair treatments, manicures, and pedicures.
As the pandemic hit, the Metro Manila salons were closed to
avoid the spread of the virus. Many employees were
retrenched and laid-off from work because no customers were
availing of the services.

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 Back to Operation

Closer
Look

The IATF eased the pandemic restrictions to alert level 2,

wherein salons can now operate at 50% capacity. Mary Salon
decided to re-open their operations by purchasing additional
tools in cash and hygiene kits on account. The revenue of the
salon was back to normal as many customers availed the
services.

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 Back to Operation

Closer
Look

Additional tools and hygiene kits are considered assets.

However, hygiene kits were purchased on account, and it is
considered a liability. The revenue of the salon is part of the
owner’s equity.

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 Check Your Progress

1 What is the relationship between assets, liabilities, and

equity as expressed by the accounting equation?

Answer area

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 Normal Balance of Accounts

● business transactions are

sorted and recorded into
different accounts:
○ assets
○ liabilities
○ capital
○ revenue
○ expenses
○ drawings

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 Normal Balance of Accounts

● indicates where each type

of account increases in its
values
● journal entry: debit and
credit

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 Normal Balance of Accounts

Debit Credit

● assets ● liabilities
● drawings ● revenues
● expenses ● equity

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Normal Balance of Accounts

Example:
When assets are increased, the
corresponding values should be
debited, or placed on the debit
side when reflected on the
different financial records.

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 Normal Balance of Accounts

Real or Permanent Temporary or

Account Nominal Account

● assets, liabilities, capital ● revenue and expenses

● recorded in the ● reported in the
statement of financial statement of profit or
position loss

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 Debit and Credit

Closer
Look

Build Inc., is a company that supplies construction materials. It

allowed one of its clients to purchase ₱100,000 worth of
materials on short-term credit. The said transaction will change
the the accounting equation to:

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 Debit and Credit

Closer
Look

In this transaction, two entries were made. First, the accounts

receivable increased the assets of the company and is
expected to have a debit balance. The other part of the entry
reflects the increase in owner’s equity as a credit entry. The
transaction is recorded in the journal as:

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 Debit and Credit

Closer
Look

Account titles Debit Credit

Accounts Receivable 100,000
Revenues 100,000

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 Check Your Progress

2 How can the accounting equation help in measuring and

recording business transactions?

Answer area

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 Road to Recovery

Case S
tu dy

The United Nations Industrial Development Organization

(UNIDO) conducted a survey to assess the impact of COVID-19
pandemic restrictions. It found out that Philippine enterprises
would need various types of assistance to recover successfully.

United Nations Industrial Development Organization, “Impact Assessment of COVID-19 on the Philippine’s Manufacturing Firms,”
https://www.unido.org/sites/default/files/files/2021-03/UNIDO%20COVID19%20Assessment_Philippines_FINAL.pdf, last accessed
on February 8, 2022. 42
 Road to Recovery

Case S
tu dy

Most firms identified cash flow bottlenecks as the biggest

challenge to recovery. Hence, these firms plan on taking out
loans to serve as their working capital for recovery and pay tax
obligations and other existing loans. Micro-, small- and
medium-sized enterprises estimated that they would need ₱2
million to ₱20 million recovery funds. They asked the
government to assist in their recovery through tax rate
deductions, tax deferrals, and waivers of penalties.
United Nations Industrial Development Organization, “Impact Assessment of COVID-19 on the Philippine’s Manufacturing Firms,”
https://www.unido.org/sites/default/files/files/2021-03/UNIDO%20COVID19%20Assessment_Philippines_FINAL.pdf, last accessed
on February 8, 2022. 43
 Road to Recovery

Case S
tu dy

According to UNIDO, unless enterprises use their loans to

develop robust sustainability aspects of their businesses, their
balance sheets will be weak. Hence, the institution
recommended business, tax, and fiscal reforms to aid
Philippine enterprises in their recovery.

United Nations Industrial Development Organization, “Impact Assessment of COVID-19 on the Philippine’s Manufacturing Firms,”
https://www.unido.org/sites/default/files/files/2021-03/UNIDO%20COVID19%20Assessment_Philippines_FINAL.pdf, last accessed
on February 8, 2022. 44
Keep in Mind

● Accounting has an established system for recording financial

transactions to reflect their effects on assets, liabilities, and equity.
The foundation of this system is the accounting equation.

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Keep in Mind

● The basic accounting equation expresses the relationship between

assets, liabilities, and equity. In the expanded accounting equation
form, the revenue and expenses are considered.

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Keep in Mind

● The main objective of the accounting equation is to keep these

accounts in balance. The equation signifies that any transaction that
changes the left side would correspond to a change on the right side.
● The normal balance indicates where each type of account increases
in its values. Assets, expenses, and drawings have debit normal
balances while liabilities, capital, and revenue have credit normal
balances.

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Keep in Mind

● Assets, liabilities, and capital are real or permanent accounts, which

are reported in the statement of financial position or balance sheet.
Meanwhile, revenue and expenses are nominal or temporary
accounts recorded in the statement of profit or loss.

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 Try This
Modified True or False. Say true if the statement is correct. Otherwise,
replace the underlined word to make the statement correct.

1. Liabilities are equal to assets plus owner’s equity.

Answer area

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 Try This
Modified True or False. Say true if the statement is correct. Otherwise,
replace the underlined word to make the statement correct.

2. Assets used in the business have financial value.

Answer area

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 Try This
Modified True or False. Say true if the statement is correct. Otherwise,
replace the underlined word to make the statement correct.

3. Equity is the residual interest in the assets of an entity that

remains after adding all its liabilities.
Answer area

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 Try This
Modified True or False. Say true if the statement is correct. Otherwise,
replace the underlined word to make the statement correct.

4. Assets, liabilities, and owner’s equity are presented in the

statement of financial position.
Answer area

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 Try This
Modified True or False. Say true if the statement is correct. Otherwise,
replace the underlined word to make the statement correct.

5. An increase in revenue has a normal balance of debit.

Answer area

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 Practice Your Skills

Read the business case and answer the following question.

Jan Martin plans to start a business. He decided to open an

internet café under the name of JM Internet Café. He invested
₱500,000 as start-up capital. He used the investment to buy ten
desktop computers for ₱400,000, and two printers for ₱75,000.
The total amount of the purchase is ₱475,000. The remaining
capital after the purchase is ₱25,000. He decided to purchase
ten tables and chairs worth ₱50,000 on account, which he
would pay next month.

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Practice Your Skills
Analyze the business transactions in the paragraph carefully.
Identify and classify each transaction that affects the assets,
liabilities, and owner’s equity account.

Asset Liabilities Owner’s Equity

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 Challenge Yourself
Answer the following questions:

1. Are incurred debts and obligations an indication of poor

financial management? Justify your answer.

Answer area

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 Challenge Yourself
Answer the following questions:

2. How does the accounting equation help in verifying the

accuracy of financial records?

Answer area

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Photo Credits

Slide 1: Financial analysis accounting, by mohammed _hassan is free to use under the Pixabay license via Pixabay.

Slide 3: black ceramic mug, by Kelly Sikkema is licensed under Unsplash License via Unsplash.

Slide 4: person holding pencil, by Scott Graham is licensed under Unsplash License via Unsplash.

Slide 5: black and white Texas Instruments, by Ray Reyes is licensed under Unsplash License via Unsplash.

Slide 6: white printer papers, by Kelly Sikkema is licensed under Unsplash License via Unsplash.

Slide 34: five black rocks, by Colton Sturgeon is licensed under Unsplash License via Unsplash.

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Bibliography

Gilbertson, Claudia, Mark Lehman. Century 21 Accounting. Ohio: South-Western Cengage Learning, 2008.

IFPRS Foundation. “Conceptual Framework for Financial Reporting.” IFRS. Accessed November 28, 2021.
https://www.ifrs.org/issued-standards/list-of-standards/conceptual-framework/.

Stanford University Fingate. “Statement of Financial Position.” Accessed February 9, 2022.

https://fingate.stanford.edu/managing-funds/statement-financial-position#anchor-1421.

United Nations Industrial Development Organization. “Impact Assessment of COVID-19 on the Philippine’s
Manufacturing Firm.” Accessed February 9, 2022.
https://www.unido.org/sites/default/files/files/2021-03/UNIDO%20COVID19%20Assessment_Philippines_FINAL.
pdf.

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