Topic 1: Accounting Equation and Double-entry System
In order to understand the concept of accounting, one needs to grasp the concept of accounting
equation first. The basic accounting equation is:
Assets = Liabilities + Owner's Equity
The expanded version is:
Assets
Current Asset
+
Non-Current Asset
=
Liabilities
Current Liabilities
+
Non-Current
Liabilities
+
Owner's Equity
Beginning Capital +/Net Income or Net Loss +
Additional Investment –
Withdrawal
This equation is the fundamental of every journal entry, thus, the foundation of the financial
statements. The accounting equation is the product of the usage of Double- Entry System which
means that in every transaction, there is always two or more accounts affected, and that, there
is always at least one account debited and one account credited. Net income is computed as the
difference between Income and Expense. In any case, if income is greater than expense, result is
net income which is added to equity; if expense is greater than income, result is net loss which is
deducted from equity.
Elements of Financial Statements
1. Assets – a present economic resource controlled by the entity as a result of past events.
These are basically the resources used by company in generating income, paying expenses
and settling maturing obligations. These can be classified as either current or noncurrent.
➢ Current Assets- an asset is considered current if it is either of the following: (1) held for
the purpose of being traded, or (2) expected to be realized or consumed within 12
months after the end of reporting period or operating cycle which ever is longer.
Common examples of current assets are as follows:
• Cash
• Inventory
• Account receivable
• Notes receivable
• Prepaid expense
➢ Non-current assets- if an asset doesn't meet the definition of current asset, it is
considered as non-current assets.
Common examples of non-current assets are as follows:
• Property, Plant and Equipment
• Accumulated Depreciation
• Intangible Assets
• Long- Term Investments
2. Liabilities- A present obligation of the entity to transfer an economic resource as a result
of past events. These are dues the company owe to other parties to provide more fund in
the short- term and long- term operation of the company. The se can be classified as either
current or noncurrent.
➢ Current Liabilities - A liability is considered current if it is either of the following: (1) held
primarily for the purpose of trading, or (2) due within 12 months after the end of the
balance sheet date. In other words, they are expected to be paid in the next year.
Common examples of current liabilities are as follows:
• Accounts Payable
• Notes Payable
• Accrued Liabilities
• Unearned Revenues
• Current Portion of Long- Term Debt
➢ Non-current liabilities- if a liability doesn't meet the definition of current liability, it is
considered as non-current liability.
Common examples of non-current liabilities are as follows:
•
3. Expense – Decrease in economic benefit or incurrence of liability that results in decrease
of equity other than the withdrawals of owners. Usually incurred to generate an income.
Let's break down the words used in the definition
• Decrease in economic benefit – decrease in asset
• Incurrence of liability – increase in liability
• Results in decrease of equity – there must be an adverse or negative effect to the
entity
• Other than the withdrawals of the owner- the decrease in asset or increase in liability
must be a result of outside transactions.
The definition of expenses encompasses expenses and losses.
Expenses – arises in the course of ordinary activities of the enterprise. There are
various classes of expenses but they are generally classified as cost of services
rendered or cost of goods sold, distribution or selling expenses, administrative
expenses or other operating expenses.
Losses – represent other items that meet the definition of expenses and may or
may not, arise in the course of ordinary activities of an enterprise. Losses
represent decreases in economic benefits and as such are no different in nature
from expenses.
Typical Account Titles Used
Cost of Sales – The cost incurred to purchase or to produce the products sold to customers
during the period; also called cost of goods sold.
Salaries or Wages Expense – Includes all payments as a result of an employer-employee
relationship such as salaries or wages, 13th month pay, cost of living allowance, overtime
pay, hazard pay, holiday pay and other benefits.
Telecommunications, Electricity, Fuel and Water Expense – expenses related to the use
or consumption of telecommunication facilities, electricity, fuel and water. This is also
called Utilities Expense
Rent Expense – Expense for rentals for space, equipment or other assets used in the
business
Supplies Expense – Expense of using supplies (e.g. office supplies, store supplies) in the
conduct of operations
4. Income- Increase in economic benefit or decrease in liability that results in increase of
equity other than the investments of the owners. Usually earned as a result of incurring
expenses.
Let's break down the words used in the definition
• Increase in economic benefit – increase in asset
• Results in increase of equity – there must be a positive effect to the entity
• Other than the investments of the owners - the increase in asset or decrease in liability
must be a result of outside transactions.
The definition of income encompasses both revenue and gains:
Revenue – arises in the course of the ordinary activities of an enterprise and is
referred to by a variety of different names including, sales, fees, etc.
Gains – represent other items that meet the definition of income and may, or may
not, arise in the course of ordinary activities of an enterprise. Gains represent
increases in economic benefits and as such are no different in nature from
revenue.
Typical Account Titles Used
Service Income – Revenues earned by performing services for a customer or client; for
example, accounting services by a CPA firm, Haircut services by a Salon, Construction
Services by an Engineering Firm.
Sales – Revenues earned as a result of sale of merchandise; for example, sale of furniture
by firm whose main line is about manufacturing furnitures.
5. Owner’s Equity- Also known as net assets or equity, capital refers to what is left to the
owners after all liabilities are settled.
Capital – This account is used to record the original and additional investments of
the owner of the business entity. It is increased by the amount of profit earned
during the year or is decreased by loss. Cash or other assets that the owner may
withdraw from the business ultimately reduce it. This account title bears the name
of the owner.
Withdrawals – When the owner of a business entity withdraws cash or other
assets, such are recorded in the drawing or withdrawal account rather than
directly reducing the owner’s equity account.
Income Summary – It is a temporary account used at the end of the accounting
period to close income and expenses. This account shows the profit or loss for the
period before closing to the capital account.
THE ACCOUNT
The basic summary device of accounting is the account. A separate account maintained for
each element that appears in the balance sheet (assets, liabilities and equity) and in the
income statement (income and expense). Thus, an account may be defined as a detailed
record of the increases, decreases and balance of each element that appears in an entity’s
financial statements. The simplest form of the account is known as “T-account” because of
its similarity to the letter “T”.
ACCOUNT TITLE
Left
Debit side
Dr.
side
or Right side or
Credit side
Cr.
Exercises: Accounting Equation and Double-entry System
Choose the best answer.
1. Which of the following accounting equations is correct?
1. Non-current assets + Current assets = Non-current liabilities – Current liabilities +
Capital
2. Assets – Liabilities = Capital + Revenue – Expenses
3. Capital + Non-current liabilities = Non-current assets + Working capital
a. (1) and (2) only
b. (1) and (3) only
c. (2) and (3) only
d. (1), (2) and (3)
2. Which of the following is correct under the double- entry system?
a. Asset amount must be equal to liability account
b. The change in asset must be compensated by a change in liability
c. The change in a debit-side entry must be compensated by a change in credit-side
entry
d. An increase in asset must be compensated by a decrease in asset
3. Which of the following statements is correct?
1. The total amount of liabilities can be greater than the total amount of capital
2. Asset = Capital + Liabilities
3. The total amount of asset can be greater than the sum of liabilities and capital
a. (1) and (2) only
b. (1) and (3) only
c. (2) and (3) only
d. (1), (2) and (3)
4. Which of the following statements regarding the double-entry system is incorrect?
a. An increase in asset means a credit entry in assets account
b. A decrease in liability means a debit entry in liabilities account
c. An increase in drawings means a debit entry in capital account
d. A decrease in non-current asset means a credit entry in assets account
5. Which of the following is correct if the sole proprietor of an entity borrows P30,000
in the name of the entity and deposits it into the entity’s bank account?
a. assets of the entity increase by P30,000
b. The liabilities of the entity decrease by P30,000
c. The capital of the entity increases by P30,000
d. The drawings of the entity increase by P30,000
6. Which of the following transactions affects the total value of liabilities of a firm?
a.) goods purchased from suppliers by cash
b.) Interest received from a bank
c.) office equipment bought on credit
d.) goods sold to customers on credit
7. On May 1,2021, Chia Ohab sets up a business and brings office equipment of P50,000
and inventory of P30,000 to the business. Chia puts up P80,000 into the firm’s cash
box and P100,000 into the firm’s bank account. Meanwhile, the firm lends P50,000
cash to BCD Company and borrows P200,000 from You Do Note bank to acquire a
piece of premises.
What is the amount of total assets on May 1,2021?
a. P510,000
b. P210,000
c. P260,000
d. P460,000
8. If during the accounting period the assets decreased by P10,000, and equity increased
by P2,000, then how did liabilities change?
a.) Increased by P12,000
b.) Increased by P8,000
c.) Decreased by P12,000
d.) Decreased by P8,000
9. If during the accounting period the assets increased by P14,000, and equity increased
by P4,000, then how did liabilities change?
a.) Increased by P10,000
b.) Increased by P4,000
c.) Decreased by P4,000
d.) Decreased by P10,000
10.If during the accounting period the assets increased by 30,000 and Liabilities
decreased by P8,000, then how did equity change?
a.) Increased by P22,000
b.) Increased by P38,000
c.) Decreased by P22,000
d.) Decreased by P38,000
11. Which of the following statements is incorrect?
a. The settlement of a liability requires cash payment
b. Liabilities can result from accepted trade practices or business commitments.
c. An estimated amount may be assigned to a liability when it is presented in the
balance sheet.
d. Liabilities represent present economic obligations that would future settlement
12.Which of the following statements is incorrect?
a. The term income encompasses both realized and unrealized gains.
b. The term income encompasses both revenues and gains.
c. Recognition of income is generally accompanied by a simultaneous recognition of
an asset.
d. Income is recognized only when cash is collected from the client or customer
13.Which of the following transactions will increase the total assets of the business?
a. a customer’s payment, to apply on his open balance
b. Bought an equipment, on cash basis
c. Bought an equipment, on account basis
d. Paid utilities expense incurred.
14. An account has the following uses, except
a. Sorting device that is used to be able to group the business transactions by
accounting elements.
b. Sorting device that is used to summarize the net effect of the transactions one each
accounting element.
c. Source of the balances that are reported in the financial statements.
d. Accounting device used to detect errors committed
15.Which of the following statements is incorrect?
a. The owner’s equity represents the claim of the owner over the assets of the
business.
b. The owner’s equity increases as a result of additional investments and net income
of the business.
c. The income and expenses of the business enterprise affect the owner’s equity.
d. Debit means increase, and credit means decrease